Written by: Jill Goodwin
Shrink Your Losses: Techniques to Properly Assess Capital Expenditures
Capital expenditures are the funds a company uses to obtain, upgrade, and maintain its physical assets. These assets include, but are not limited to, buildings, equipment, technology, plants, and property.
Capital expenditure, also referred to as CapEx, is often used in the undertaking of new investments or projects. Making CapEx on fixed assets can include repairing equipment, building new offices and factories, or upgrading current facilities. Businesses make this form of financial outlay to expand or maintain their company operations.
A financial advisor must assist a business in assessing its CapEx. By doing this they can ensure consistent and sustainable growth and scalability, and minimize financial losses in the interim.
We can represent a basic CapEx formula as follows:
[CapEx = Net Increase in PP&E(property, plant and equipment) + Depreciation Expense]
Essentially, CapEx is a payment of services and goods recorded or capitalized. It should be recorded on a business’s balance sheet instead of listed as an expense on its income statements. Capital expenditure spending is crucial for companies who want to maintain their existing equipment and property, invest in new technologies, and obtain additional assets that are integral to their growth.
It’s important to note that if any business-related items have a useful lifespan of less than 12 months, they must be listed as an expense on an income statement rather than capitalized. These assets cannot be considered CapEx.
Capital Expenditure vs Revenue Expenditure
As outlined above, capital expenditure is used to purchase or improve the capacities of long-term assets like buildings and equipment. Each asset’s cost is allocated as a depreciation expense over its useful lifespan. Then, the amount of each period’s depreciation expenses is credited to the Accumulated Depreciation account.
Examples of capital expenditures include the sums used to buy or improve assets like land, buildings, fixtures, furnishings, and vehicles.
CapEx should not be confused with revenue expenditure. A revenue expenditure is an amount spend for an expense that will be immediately matched with revenues shown on the current period’s income statement.
Everyday examples of revenue expenditures include sums spend on sales, administrative costs, and repair and maintenance charges.
What CapEx Spending Can Tell You
A company’s CapEx can inform you of several key indicators of growth and sustainability. It can tell you how much is being invested in new and existing fixed assets in order to maintain or grow operations.
The individual CapEx figures will largely depend on the industry in which it operates. Many of the most capital-intensive sectors have high levels of CapEx, including the telecommunications, manufacturing, utilities, and oil exploration industries.
Different businesses highlight their CapEx in varying ways, so investors and analysts could see it listed as purchases of PP&E, capital spending, or acquisition expenses.
You can calculate a business’s CapEx by using information from the company’s income statements and balance sheets. Locate the amount of depreciation expense for a given period on the income statement, then find the period’s PP&E line-item balance to calculate the capital expenditure.
Next, find the company’s prior-period PP&E balance, and calculate the difference between the two figures to determine the change in its PP&E balance. Add the change in PP&E to current depreciation expense figures to determine the business’s current period CapEx expenditure.
Techniques for Assessing Capital Expenditure
Certain capital expenditures are chosen out of necessity. A good example would be a government requirement to alter the system for expelling environmentally hazardous emissions, or to comply with other state restrictions.
Financial advisors can use the techniques listed below to evaluate other CapEx spend after budgeting for the required expenditures.
- Accounting Rate of Return
Also called Return on Investment (ROI), this approach assesses the increase in accounting profits in comparison with increased investments. This technique doesn’t take into account the time value of money.
This technique determines how many years it will take to recuperate the cash spend on a project or task. Payback has one notable drawback; it doesn’t consider the time value of money or cash flows over the entire lifespan of the project in review.
- Internal Rate of Return
This method takes into account the time value of money and considers cash flows over a project’s lifespan. The technique assesses the rate that will discount future cash flows to equalize them with a project’s cash outlay.
- Net Present Value
This technique discounts a project’s future cash flows using a predetermined rate—usually the needed or targeted rate. If the cash flows that have been discounted using this method exceed the value of the cash investment, the project gets the green light. It’s able to provide the targeted return at the least.
CapEx Assessment in a Nutshell
The process of closely assessing CapEx typically involves plenty of calculations and numbers. However, the approach is relatively simple.
We’ll explain by using the example of a total assessment of the purchase process.
Assessing Purchase Viability
If a company wants to make a purchase, you need to assess the overall benefits of this purchase relative to the cost of ownership they’re facing. You cannot simply look at increases in gross profits to gauge whether or not a purchase will be a solid investment.
Instead, you need to work backwards to ensure it’s a smart decision.
In this case, you would establish:
The increase in production capacity (per unit) for a period and the additional gross profit for that period
Once this is established:
deduct the cost of ownership for the period from the gross profit
Then, you can simply determine your new gross profit per unit by:
Taking this total and dividing it by your increased capacity per unit.
Production CapEx Examination
A business also needs to analyze the pros and cons of a capital expenditure for production. You can do this by gauging current production capacity, gross profits, and cycle times. Thereafter you can decide how much to increase capacity through the purchase of additional equipment.
When a business was established, it should have included information on how it would scale up in its business plan. This section can be updated as a business grows, and any increase in capacity and production charted accordingly. This plan may also be integral in determining how to implement additional equipment and ensure it reaches its maximum profit potential.
When it comes to calculating production CapEx, begin by assessing current production levels and determining ideal future levels of production. Once you have these numbers in place, any steps you take thereafter should ensure a business meets its goals according to plan.