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 long-term investments, meaning the assets purchased have a useful life of one year or more.
- A capital expenditure (CapEx) is the money companies use to purchase, upgrade, or extend the life of an asset.
- Capital expenditures are long-term investments, 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.
- CapEx can be a one-time expenditure (i.e. buying land) or accumulated over time as part of a project (i.e. developing a building on that land).
- In accordance with GAAP, CapEx must be capitalized on a company's balance sheet and recognized as an expense over the life of the asset.
Understanding Capital Expenditures (CapEx)
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.
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.
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.
International or foreign companies may report their financial statements under International Financial Reporting Standards (IFRS) instead of Generally Accepted Accounting Principles (GAAP). Be mindful of capitalization rule differences between the two codifications especially as it relates to IAS 16.
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 a 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. There is a fine line between what is considered a repair (not extending the useful life of the asset) and a capital upgrade.
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 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 CapEx spending and can be depreciated if they meet specific criteria. Accounting guidance rules that some internal research and development expenses related to creating a new software must be capitalized and depreciated over the life of the asset. This may include fees paid to external parties that assisted with the software development, costs to obtain long-term software, payroll for employees that worked on the development, or travel in connection with the development.
Technology and computer equipment, including servers, laptops, desktop computers, and peripherals would be capital expenditures if they fit the appropriate criteria. Equipment must have a useful life of greater than one year. In addition, a company may set an internal materiality threshold as to not capitalize every calculator purchased and held for greater than a year.
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, regardless of whether they were purchased outright or financed with debt. However, the costs associated with leasing vehicles are treated as operational expenses.
Some capital assets such as vehicles often have salvage value at the end of their useful life. The salvage value reduces the amount of depreciation recognized over the life of the asset as the company expects to recover some costs at the end of the asset's life.
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.
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 may 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 2019, 2020, 2021, from the company's annual report.
Capital expenditures are shown as (negative numbers) under investing activities.
- Tesla listed purchases of property and equipment (highlighted in blue) for $6.5 billion in 2021, $3.2 billion in 2020, and $1.3 billion in 2019.
- The company also listed as capital expenditures the purchase of solar energy systems (highlighted in blue) for $32 million in 2021, $75 million in 2020, and $105 million in 2019.
How Are Capital Expenditures Reported?
Capital expenditures are reported on the balance sheet as assets. The initial journal entry to record their acquisition may be offset with a credit to cash if the asset was purchased outright, debt if the asset was financed, or equity if the asset was acquired via an exchange for ownership rights.
As capital expenditures are used, they are depreciated. Depreciation is reported on both the balance sheet and the income statement. On the income statement, depreciation is recorded as an expense and is often classified between different types of CapEx depreciation. On the balance sheet, depreciation is recorded as a contra asset that reduces the net asset value of the original asset acquired.
What Is the Difference Between Capital Expenditures and Operating Expenditures?
Capital expenditures are larger, often one-time purchases of fixed assets that are intended to be used for a long time. If a company buys a new vehicle for the company fleet, the vehicle is considered a capital expenditure.
Operating expenditures are smaller, usually more frequent purchases that support the operations of the company by secure value in the short-term. For example, if the company goes to fill up the new fleet vehicle with gasoline, the entire benefit of the full tank of gas will likely be utilized in the short-term. Whereas the vehicle will probably still have value next year, the tank of gas will be long gone. Therefore, the cost to fill up the gas tank is considered an operating expense.
Is Maintenance a Capital Expense?
In general, maintenance is not a capital expense. Both repairs and maintenance are considered operating expenses as their incurrence does not extend the life of the underlying asset. R&M is seen as not changing the underlying long-term value of the asset, therefore maintenance costs are almost always expensed immediately.
The Bottom Line
Companies often incur capital expenditures to invest in their long-term capabilities. Companies may do so by buying land to expand to new regions, buildings to enhance manufacturing or warehouse opportunities, or technology to make their business more efficient. If an asset is likely to deliver long-term benefits to a company, the company may be required to record the purchase or development as a capital expenditure, depreciate the asset over its useful life, and maintain part of the purchase on its balance sheet.