What Is A Capital Expenditure?
A capital expenditure is the act of a company using funds in order to purchase, improve, or maintain its long-term assets. These assets typically include property, plants, equipment, or other assets which will be kept longer than a single fiscal year. Companies use capital expenditures in order to reinvest funds with the hopes of benefiting their business.
Reading Capital Expenditures
A company’s capital expenditures during a given period are recorded on its cash flow statement under “cash from investing activities.” Because capital expenditures represent outflow of cash, the total monetary amount a company spends on CapEx will be represented by a negative number. While it is commonly referred to as capital expenditures, the purchase of long-term assets may also be reported under the following titles: acquisition expense, purchases of PP&E, or capital spending. However, CapEx is not difficult for an individual to calculate using the formula below.
Capital Expenditures = Increase in PP&E + Depreciation Expense
Where:
PP&E: Property, Plants, and Equipment
Increase in PP&E: Current PP&E – Prior PP&E
Analyzing Capital Expenditures
Companies almost always have capital expenditures recorder on their cash flow statement. As a stand alone number, CapEx can’t tells you very little. However, properly analyzing a company’s capital expenditures may prove highly useful to investors. It is always important to understand why a company has a certain amount of capital expenditures reported and what they are purchasing. To determine the soundness of the company’s investment, one must understand how the purchased/fixed asset will produce economical benefit which will exceed the cost it required. Before committing to a capital expenditure, companies often calculate net present value to gauge the soundness and efficiency of the investment. Another way investors can analyze capital expenditures is by comparing it to the amount of capital a firm is generating. Of course, a company can not sustainably expend a sky high percentage of the capital it is generating. This concept may be quantified by calculating the cash flow to capital expenditures ratio using the formula below.
Cash Flow To CapEx Ratio = Operating Cash Flow / CapEx
Example of CapEx
Suppose a privately-held manufacturing company is considering a $10 million CapEx plan to upgrade its production equipment. The company’s management team would start by evaluating the current state of their equipment, such as its age, efficiency, and maintenance costs. They would also assess the competitive landscape to determine if the new equipment is necessary to maintain their market position and profitability.
Next, the company would conduct a cost-benefit analysis of the CapEx plan, estimating the potential savings from increased efficiency and reduced maintenance costs against the investment required. They would also consider the potential impact on employee productivity and morale, as well as any regulatory or compliance requirements.
The company would then assess its financial capacity to fund the investment, evaluating its current cash flow, debt levels, and other financial obligations. They would also consider alternative financing options, such as bank loans or leasing agreements.
Once the company has determined the feasibility of the CapEx plan, they would develop a project plan and timeline, including milestones and key performance indicators to track progress. They would also identify potential risks and mitigation strategies, such as supplier or contractor delays, cost overruns, or unforeseen technical issues.
Finally, the company would implement the CapEx plan, monitoring progress against the project plan and adjusting as necessary. They would also evaluate the return on investment after completion, comparing actual results against their initial cost-benefit analysis and assessing the overall impact on the company’s financial health and competitive position.
Through this analysis, the company can make an informed decision about whether the CapEx investment is the right strategic choice for the business and whether it is likely to generate a sufficient return on investment.
Why Capital Expenditures?
In conclusion, capital expenditures can provide great economic benefit to companies if they are preformed correctly, as with any investment. Capital expenditures should not be purposefully avoided as they are necessary in the acquisition of both tangible and intangible assets.
