What Is a Capital Expenditure (CAPEX)?
A capital expenditure (CAPEX) is an investment in a business, such as a piece of manufacturing equipment, an office supply, or a vehicle. A CAPEX is typically steered towards the goal of rolling out a new product line or expanding a company's existing operations. Money spent on CAPEX purchases is not immediately reported on an income statement. Rather, it is treated as an asset on the balance sheet, that is deducted over the course of several years as a depreciation expense, beginning the year following the date on which the item is purchased.
CAPEX and the Income Statement
Every year in which this depreciation expense is reported on the income statement effectively reduces a company’s profit. To cite an example, if a flower shop owner purchases a delivery van for $30,000, that vehicle is recorded as an asset on the balance sheet that same year, but that year’s income statement remains unaffected by the purchase.
Let us further assume that the store owner plans to use the van for six years, where the vehicle annually depreciates by $5,000. Under this set of circumstances, the following year’s income statement would report a $5,000 expense. To reiterate: a CAPEX does not directly affect income statements in the year of a purchase, but for each subsequent year for the expected useful life of the asset, the depreciation expense affects the income statement.
There are often purchases related to a CAPEX, that do in fact, immediately affect an income statement, depending on the type of asset acquired. Using the flower shop example, although the purchase price of the van is not recorded on the income statement for that year, ancillary costs such a gas, auto insurance and vehicle maintenance bills are considered business expenses, that would show up on the company’s income statement. However, it is worth noting that these expenses may be offset by the increase in revenue that could potentially result from increased sales activity, due to expanded delivery capability.
CAPEX Versus Operational Expenses
While CAPEX refers to the money spent on tangible assets that will be used for longer than twelve months, operational expenses refer to money spent on the usual operations of a company. While CAPEX investments appear on the cash flow statement under the investing section, operational expenses appear on the income statement as expenses, with the corresponding amount appearing on the balance sheet, either as a cash reduction or accounts payable increase.
Free Cash Flow and CAPEX
Although CAPEX is often laid out in the cash flow statement, there is a great value to understanding all the components. To that end, an investor may calculate a period’s CAPEX with the following formula:
CAPEX = Plant, property, and equipment (PPE) for the current period - PPE for the previous period + depreciation expense
In essence, CAPEX reduces free cash flow, which is calculated as operating cash flow, less CAPEX. However, CAPEX is seen as an investment, used to purchase or improve an existing asset.