A capital expenditure (CAPEX) is the money companies use to purchase, upgrade, or extend the life of an asset. Capital expenditures are designed to be used to invest in the long-term financial health of the company. Capital expenditures are a long-term investment, meaning the assets purchased have a useful life of one year or more.
Although the expenditures are beneficial to a company, they often require a significant outlay of money. As a result, companies must budget properly to effectively generate the revenue needed to cover the cost of the capital expenditure.
- A capital expenditure (CAPEX) is the money companies use to purchase, upgrade, or extend the life of an asset.
- Capital expenditures are a long-term investment, meaning the assets purchased have a useful life of one year or more.
- Types of capital expenditures can include purchases of property, equipment, land, computers, furniture, and software.
Understanding Capital Expenditures (CAPEX)
Capital expenditures are often employed to improve operational efficiency, increase revenue in the long term, or make improvements to the existing assets of a company. Capital spending is different from other types of spending that focus on short-term operating expenses, such as overhead expenses or payments to suppliers and creditors.
Investors and analysts monitor a company's capital expenditures very closely because it can indicate whether the executive management is investing in the long-term health of the company.
CAPEX and Depreciation
Depreciation is used to expense the fixed asset over its useful life. Depreciation helps to spread out the cost of an asset over many years instead of expensing the total cost in the year it was purchased. Depreciation allows companies to earn revenue from the asset while expensing a portion of its cost each year until the asset's useful life has ended.
For example, if an asset costs $10,000 and is expected to be in use for five years, $2,000 may be charged to depreciation in each year over the next five years. There are several methods used to calculate depreciation. The full value of costs that are not capital expenditures must be deducted in the year they are incurred.
Capital Expenditures Limits
There are capitalization limits, which specify that the price of assets must be greater than to be depreciated over time rather than charged entirely as an expense in the current year. The cost of record-keeping associated with depreciation causes capitalization limits to be put into effect. Costs that are not depreciated and are associated strictly with operational matters are known as operational expenditures.
Types of Capital Expenditures (CAPEX)
Below are some of the common types of capital expenditures, which can vary depending on the industry.
Buildings and Property
A purchase or upgrade to a building or property would be considered capital purchase since the asset has a useful purpose for many years. Purchases of property, plant, and equipment are often facilitated using secured debt or a mortgage, for which the payments are made over many years.
Interest expenses associated with debt financing may be depreciated as well as the cost of the asset. However, costs incurred with an issue of stock would not qualify for depreciation.
Upgrades to Equipment
In the manufacturing industry and other industries, machinery used to produce goods may become obsolete or simply wear out. Upgrades to the equipment are often are needed. If these upgrades are higher than the capitalization limit that is in place, the costs should be depreciated over time. Similar to buildings or property, equipment upgrades are often financed. The cost of this financing may be depreciated as well.
Software expenditures are a significant cost for large companies. Costs to upgrade or purchase software are considered Capes spending and can be depreciated.
Technology and computer equipment, including servers, laptop, desktop computers, and peripherals would be capital expenditures.
Companies often need a fleet of vehicles for distribution or to carry out services for customers, such as delivery companies. These vehicles are considered capital expenditures. However, the costs associated with leasing vehicles are treated as operational expenses.
Assets for capital expenditures don't all need to be physical assets or tangible, but instead, can be intangible assets. If a company purchased a patent or a license, it could be considered a capital expenditure.
Capital expenditures usually involve a significant outlay of money or capital, which often requires the use of debt. Given the expensive nature of capital expenditures, investors closely monitor how much debt is being taken on by a company to ensure the money is being spent wisely.
Long-term debt includes debt-servicing costs, such as interest expenses. Companies must generate enough revenue to be able to service the debt payments as well as the interest payments.
Although capital expenditures are an indicator for demonstrating the level of investment in a company by its management, too much debt can put the company into financial trouble.
Also, capital expenditures that are poorly planned or executed can also lead to financial problems in the future. For example, if a company's management team buys new technology that quickly becomes obsolete, the company would be stuck with the debt payments for many years without much revenue generated from the asset.
Some industries are more capital-intensive than others, such as the oil and gas industry where companies need to buy drilling equipment. As a result, it's important for investors to compare the capital expenditures of one company with other companies within the same industry.
Real-World Example of Capital Expenditures
The cash outflows from capital expenditures are listed on a company's cash flow statement under the investing activities section. The cash flow statement shows a company's inflows and outflows of cash in a period.
Capital expenditures are an outflow of cash listed within investing activities. However, if a company borrowed money for capital expenditures, it would be listed as an inflow of cash in the financing activities section and an outflow of cash in the investing activities section.
Below is an example of the cash flow statement for Tesla Inc. for years ending 2017, 2018, 2019, from the company's quarterly financial results.
Capital expenditures are shown as (negative numbers) under investing activities.
- Tesla listed purchases of property and equipment (highlighted in blue) for $1.3 billion in 2019, $2.1 billion in 2018, and $3.4 billion in 2017.
- The company also listed as capital expenditures the purchase of solar energy systems (highlighted in blue) for $105 million in 2019, $218 million in 2018, and $666 million in 2017.