In accounting, a capital item is any asset, from real estate to office furniture to company vehicles, that’s carried on the balance sheet and depreciated over a set period of time.
But that’s only part of the story. Say you’re a commercial baker and need to get your products to restaurant customers. Do you spend $50,000 on a delivery van, lease that same vehicle for $350 per month or hire a contract delivery service for a variable weekly fee based on mileage?
The objective is to serve customers effectively, use available cash wisely and advance short- and long-term business goals. Companies that manage to do all three effectively tend to do a good job tracking how much they’re investing in capital versus operating costs and determining which CapEx investments generated a profit—and which emerged as financial losses.
What Are Capital Expenditures (CapEx)?
Capital expenditures are funds used to purchase, maintain or upgrade assets, such as buildings, equipment, infrastructure, computer hardware and other tangible property. Also referred to as “CapEx,” these outlays often are used to acquire and keep in good working order the means of production and distribution of the organisation’s goods and services.
GAAP rules for CapEx state that, generally, the test is whether an item has a useful life of more than one year. These assets are typically physical and non-consumable and remain on the balance sheet for multiple accounting periods.
Examples of CapEx include purchasing business vehicles, buildings, furniture, land, machinery, computer equipment, even patents and licenses that could be resold.
Types of Capital Expenditures
Capital expenditures include expenses for fostering an increase in a company’s future growth and expenses for maintaining present operating levels.
These expenses can be both tangible and intangible. However, amounts spent on conducting normal and continuous operations or upkeep should not be capitalised. Therefore, these are not period expenses on an income statement at the time they are incurred.
Capital Expenditure vs. Operating Expenditure vs. Revenue Expenditure
Say a chef decides to open a restaurant and purchases a building that formerly housed offices. The cost of the real estate, renovations needed to make the space suitable for a restaurant, fixtures and furniture, kitchen equipment and computers are capital expenses, able to be depreciated over varying periods of time.
Server salaries, food and a subscription for accounting software are considered operating expenditures, while a quarterly fee for a service technician to keep a walk-in refrigeration system in good working order is a revenue expenditure, as it refers to costs to keep a capital item in a condition to contribute to revenue generation.
What are Operating Expenses (OpEx)?
Operating expenses are ongoing costs—ordinary and necessary expenses—for the day-to-day operations required to operate the business. These can include utilities, rent, salaries, property taxes, pension plan contributions and business travel to name a few.
What are Revenue Expenditures?
Revenue expenditures are shorter-term expenditures that are made for the generation of revenues. The cost of goods sold (COGS), also referred to as the cost of sales or cost of services, is how much it costs to produce your products or services. COGS include direct material and direct labour expenses that go into the production of each good or service that is sold.
Key Differences Between CapEx, OpEx and Revenue Expenditures
Capital expenditures are for investments meant to be used for an extended time greater than one year. These purchases remain on an asset sheet for multiple accounting periods. Companies tend to prepare a separate capital expense budget to reflect costs recovered through depreciation.
For example, our restaurateur could depreciate the cost of computer systems, tables and chairs and light fixtures over these asset’s useful lives which may be five to seven years.
In contrast, OpEx and revenue expenditures are expenses required to operate a business. They make up most of an organisation’s ongoing costs. OpEx purchases will be used in the accounting period in which they are incurred.
Operating expenditures for the restaurant may include the cost of subscriptions for point-of-sale systems, food, paper goods and beverages.
Our chef has contractors who come in periodically to clean grease traps and check refrigerant levels in the walk-ins. These are recurring revenue expenditures.
CapEx Formula and Calculation
CapEx purchases made in the current year are normally presented on the company’s cash flow statement. The accumulated amount of CapEX and the associated accumulated depreciation is normally displayed on the company’s balance sheet, and subtracting the accumulated depreciation from the accumulated CapEx purchases results in the net amount of CapEx or Fixed Assets at any point in time. The amount depreciated each year is accounted for on the company’s income statement.
How to Calculate Capital Expenditures
Calculating capital expenditures includes locating the current and prior period’s property, plant and equipment (PP&E) on the balance sheet and the amortisation and depreciation on the income statement—all you need to do is look at the financial statements to get this information as this is, in effect, what the financial statements do.
To get Net Book Value of fixed assets you would just look at the balance sheet which shows total fixed assets less accumulated depreciation to arrive at net fixed assets or net book value. The income statement would show the depreciation expense recognised for the year.
The formula for valuing a capital expenditure is as follows:
CapEx = PP&E (current) – PP&E (prior) + depreciation
Example of CapEx
In 2019, the clothing supplier that provides uniforms to our restaurant purchased new computers and expanded its facilities to grow revenue.
After looking at the balance sheet and income statement, the information necessary to calculate CapEx for that year is as follows:
- PP&E at the start of 2019: $30,000
- PP&E at the end of 2019: $40,000
- Depreciation: $10,000
Taking the above values, begin by subtracting the staring PP&E value ($30,000) from the ending value ($40,000). This equals a $10,000 change in PP&E. Then, add in depreciation ($10,000), which results in a $20,000 capital expenditure.
What Does CapEx Tell You About Your Business?
Your CapEx strategy reveals how much your business is investing in new and existing fixed assets to grow or maintain revenue. Bigger picture, it also indicates how accurately and confidently leaders believe they can predict future demand using principles of scenario planning and weighing of opportunity costs versus the benefits of ownership.
Increasing income and profitability is tied to strategically sound CapEx.
For example, say our restaurateur acquired in 2019 an adjacent building and had a choice between purchasing more furniture to outfit the space as an extended dining room or expanding the kitchen with specialty equipment to launch a takeout, catering and packaged-meal business. The path our chef chose matters significantly in 2020.
In addition, making smart choices on whether to spend on a CapEx or OpEx basis reveals the effectiveness of an organisation’s finance team by making the best use of funds that will drive the greatest return on investment.
Using Capital Expenditures in Your Accounting
Capital expenditures are cash outlays for a specific accounting period, so they’re recorded on a cash flow statement—found under investing activities. They are also recorded on the balance sheet under the PP&E section as assets.
Importance of Capital Expenditures in Business
As discussed, smart capital expenditures help businesses grow. From a long-term financial planning perspective, CapEx analysis helps leaders understand whether an asset offers an attractive rate of return. That way, companies can balance maintaining existing equipment and property with having enough capital to invest in growth.
Other important considerations include:
- Initial costs: Depending on the industry, capital expenditures are generally more expensive than acquiring use of the same asset on an operating basis. Think purchasing a fleet vehicle versus leasing or signing on a contract delivery service. It’s crucial to understand the long-term benefits of owning an asset.
- Irreversibility: A company will most likely incur losses when undoing a capital expenditure. That’s because the market for capital equipment tends to be poor, which means acquired assets are likely better off used by the company itself.
- Depreciation: Once an asset is being put to use, depreciation begins and may lead to a decrease in an organisation’s asset accounts.
Challenges of CapEx
Decisions around capital expenditures can often be challenging. They’re also crucial to the well-being of a company.
The three main challenges of planning for CapEx are:
- Unpredictability: When it comes to investing in capital assets, predictions are not guaranteed simply because no one can see into the future. Although companies can and should use risk management principles and insurance to predict and offset the possibility of potential losses related to capital assets, it’s impossible to eradicate uncertainty.
- Measurement problems: Some results of capital expenditures, such as boosting employee morale, are intangible and therefore won’t be captured on a balance sheet. And, it can be complicated to measure all related costs. Take the delivery van example: a driver’s salary is OpEx, and that expense must be considered along with fuel, insurance and other costs to decide whether purchasing is better than hiring a contractor.
- Spread: Benefits related to capital expenditures are generally stretched over a longer period and can lead to problems when it comes to establishing equivalence and discount rate estimation. Simply, cash invested in capital equipment is no longer available for potentially more advantageous opportunities.
Capital Expenditures Best Practices for Business
Sound project management and effective planning are necessary to efficiently balance conserving cash versus investing for growth. Besides effective forecasting and scenario planning, here are five best practices:
- Define what success looks like. Be clear about realistic deadlines for a return on CapEx investments, the project’s scope and any OpEx resources required to realise full benefits. How does this plan rank priority-wise with other investment opportunities? What is the business rationale for the capital project?
- Create clear lines of communication. In larger companies, multiple departments might be involved in capital projects. How will you gather critical information into a dashboard and ensure everyone is on the same page with regard to expected business outcomes—and realisation of expected value for the company?
- Employ a standardised business case template for potential capital projects. Each investment proposal should be accompanied by a thorough analysis explaining its merit. A business case should identify sources of value by including a detailed rationale and an explanation of alternatives, along with a calculation of expected return or qualitative benefit, timing, context and risk.
- Look at financing options. Deciding whether to purchase a capital asset with existing funds or via a loan requires financial analysis around interest rates, debt incurred and how long the asset in question depreciates.
- Include “what ifs” in case circumstances change. Is this a “must do” type of expenditure, such as purchasing a building that a landlord indicates you will otherwise need to vacate? Or is it more about growth or a new line of business? Can you scale back and still achieve most objectives? That determination will help inform whether the organisation can decide to pull the plug and take a loss on a project if market reality and/or company fiscal health change.
- Accounting software can help your business streamline capital expenditures. Using reliable accounting software to manage capital expenditures helps reduce the risk of error. For example, missing out on deductions for depreciation can be costly, as can triggering an IRS audit.