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Importance of Capital Expenditures in Business

Importance of Capital Expenditures in Business

Importance of Capital Expenditures in Business

Expenses are a normal part of running a business. Capital expenditures are incurred when a business uses collateral or takes on debt to buy a new asset or add value to an existing asset. Capital expenses include the cost of fixed assets and the acquisition of intangible assets. CapEx spending is important for companies to maintain existing property and equipment, and invest in new technology and other assets for growth.

Capital expenditures (CapEx) are used by a company to acquire, upgrade, and maintain physical assets such as property, plants, buildings, technology, or equipment.

Importance of Capital Expenditures in Business

As discussed CapEx is often used to undertake new projects or investments by a company, 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 the 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 organization’s asset accounts.

CAPEX Examples

Capital expenditure is any amount of money spent to create a long-term benefit. When a business spends money to acquire long-term assets (assets they expect to use for at least a year), that money is the capital expenditure. Businesses spend capital expenditure funds on things like:

  • Acquiring, or buying, a fixed tangible, such as a building, or intangible assets, such as a patent or license
  • Upgrading an existing asset to expand its capacity or capability, such as a computer network or major equipment
  • Renovating an obsolete or non-functioning asset to make it usable
  • Repairing an asset to make it usable once again
  • Adapting an asset for a new use, different from what it had been previously used for
  • Starting or acquiring a new business

Operating Expense vs. Capital Expense

There are a variety of expenses that come with owning and operating a business. Two of the most common types of expenses are operating expenses and capital expenses.

Operating expense (OpEx)

An operating expense (OpEx) is an expense required for the day-to-day functioning of a business. This means a business incurs an operating expense on a recurring basis. Operating expenses include things like insurance, payroll, and marketing.

A capital expense (CapEx)

Capital expense (CapEx), on the other hand, is incurred to create a benefit in the future. They are long-term in nature and are generally used to acquire things like property, equipment, and technology.

Capital expenditure Operating expenditure
Purpose Assets meant to benefit the business for more than one year Costs to run day-to-day operations
Listed as Equipment or property Operating cost
When it is accounted for Depreciated over the asset’s useful life (in years) Current month or year

Capital Expenditures and Financial Statements

The business needs to showcase its Capital Expenditures spending on the financial statements such as the balance sheet and cash flow statement.

The business needs to list capital expenditures as assets on the balance sheet for the value of the property under the property, plant, and equipment (PP&E) category.  The assets depreciate in value over time due to wear and tear, so the business needs to adjust the value of the capital assets every year to account for the depreciation.

Businesses can track capital expenditure spending on their cash flow statement under-investment expenses, showing that money has gone toward purchasing long-term assets. The capital expenditures are listed separately from the operating expenses. Tracking where the money goes between categories is a key part of forecasting the cash flow and understanding the financial position.

Tax ax Impact on Capital Expenditures

Capital expenditures are not directly tax-deductible. However, they can reduce a company’s taxes indirectly by way of the depreciation that they generate.

Types of Capital Expenditures

There are normally two forms of capital expenditures. These expenses can be both tangible (machine) and intangible (patent)

  • Expenses for fostering an increase in a company’s future growth
  • Expenses for maintaining present operating levels.

CapEx Formula and Calculation

As mentioned above, 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.

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 amortization and depreciation on the income statement. —Businesses can get this information from the financial statements. To get the Net Book Value of fixed assets, a businessman can 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 recognized for the year.

The formula for valuing a capital expenditure is as follows:

CapEx = PP&E (current) – PP&E (prior) + depreciation

Advantages of Capital Expenditure Spending

  • It increases the production capability and revenue potential.
  • Capital Expenditure adds to the value of the business.
  • Capital Expenditure Spending could reduce long-term costs.

Disadvantages of Capital Expenditure Spending

  • The upfront cost is higher. It costs more to buy assets upfront.
  • Capital expenditure spending doesn’t stop after buying an asset. Businesses need to keep up with repairs and maintenance to protect the value of the investment
  • It’s hard to project long-term value