Capital Expenditure: An Ultimate Guideline For Small Businesses

Capital Expenditure - An Ultimate Guideline For Small Businesses

As a business owner, you already understand how vital it is to closely monitor your costs to keep your accounting in order, manage cash flow, and generally run your operations smoothly.

Having low expenditures is the simplest approach to increase your company’s profitability and keep the door open for future growth. But, as you know, not all expenses are the same. Each type of expenditure impacts your profitability in different ways. 

This article will look at capital expenditure in particular – its definition & roles in business finance, ways to differentiate it from operational expenditure, and best practices to manage it efficiently.  

What is capital expenditure? 

Capital expenditure, also known as CapEx, is the money a company spends on acquiring, upgrading, and maintaining long-term assets. Long-term or fixed assets refer to assets with a useful life of more than a year. 

A capital expense can be tangible, such as a building, or intangible, like a patent. So, capital expenditures can include the purchase of new property, plant & equipment (PP&E), the renovation of a building to enhance its longevity, or a software upgrade for new functionalities.    

Simply put, CapEx is used to make investments or add extra value to existing assets, increasing operational efficiency and profit in the long run. That’s why capital expenses might not look good for your business income now but are necessary for generating revenue and future expansion of the business.

As a result, investors and financial analysts consider CapEx a critical indicator of how much a company is spending for further progress and potential growth. 

What are some examples of capital expenditure? 

Listed below are the most typical examples of CapEx, which can vary depending on the nature of your business model & industry. 

  • Property (including any costs incurred to extend the useful life)
  • Computer/Server equipment
  • Equipment upgrades (that increase the value beyond normal maintenance)
  • Furniture and fixtures
  • Machinery (including the shipping cost to its intended location and any required costs to use the machinery)
  • Office equipment
  • Real Estate (buildings, garages, etc.)
  • Software
  • Vehicles
  • Intellectual property 

What capital expenditure can tell you

CapEx can show how much a company invests in existing and new long-term assets to sustain or expand the business. Put it another way, CapEx is the expense that a company capitalizes or shows on its balance sheet as an investment, rather than on its income statement as expenses. By capitalizing on an asset, the company will need to spread the expenditure over the asset’s useful life. CapEx can also be found from investing activities in a company’s cash flow statement. Companies highlight CapEx in various ways, and an analyst or investor may see it listed as capital spending, purchases of property, plant, and equipment (PP&E), or acquisition expense.

The amount of capital expenditures vary from different industries due to their required infrastructure and machinery. Oil exploration and production, telecommunications, manufacturing, and utility industries are among the most capital-intensive businesses with the greatest capital expenditures. 

As previously said, capital expenditures are essential in the growth of a business. In terms of long-term financial planning, CapEx analysis assists executives in determining if an asset delivers an appealing rate of return. Therefore, companies may strike a balance between preserving current equipment and property and having enough cash to engage in expansion.

How to calculate capital expenditure? 

You can also determine capital expenditures by using data from a company’s income statement and balance sheet (in case you don’t have the data available already).

To calculate CapEx, follow these four steps:

  1. Find the depreciation/amortization on the income statement.
  2. Locate the current property, plant, and equipment (PP&E) on the balance sheet.
  3. Locate the amount of PP&E from the prior period on the balance sheet.
  4. Plug the numbers in this formula:

CapEx = PP&E (Current period) – PP&E (prior period) + Depreciation expense

Example: Let’s say you own a paper company, and in 2020, you decided to spend money on new equipment and an expanded facility. You want to calculate your company’s capital expenditures for that year.

You have the following information:

  • Depreciation = $10,000
  • PP&E at the end of 2020 = $40,000
  • PP&E at the beginning of 2020 = $35,000

Now you can estimate your capital expenditure based on these figures. 

Begin by deducting the PP&E value at the start of 2020 ($35,000) from the PP&E value at the end of 2020 ($40,000). This results in a $5,000 change in PP&E. Next, add this value to the depreciation expense ($10,000). The result is the capital expenditure ($15,000) for the year 2020.

Differences between capital expenditure (CapEx) 

vs. operational expenditure (OpEx)

To many business owners, any money spent on the business is considered only as an expense. However, this is not the case from an accounting & managerial point of view. CapEx and OpEx are the perfect examples to prove just that. 

Here are five key differences between CapEx vs. OpEx so that you will never mix them up again!

  • Definition 

Whereas CapEx is used to obtain or upgrade assets that have a useful life beyond a year, OpEx is the day-to-day expenses to keep a business operating. Typical examples of operational expenditures are rent, payroll, office supplies, normal maintenance. 

  • Accounting treatment 

As CapEx acquires assets that have a useful life beyond the year they’re incurred, these expenses can’t be fully deducted right away, at one time. Instead, they’re amortized or depreciated over the life of the asset. 

However, a business can fully deduct operational expenses. As they are everyday operational expenditures rather than long-term assets, you do not need to account for depreciation like you would with CapEx. OpEx is subtracted from the revenue to calculate the profit/loss of the company.

  • Financial statements  

You will find CapEx presented in the Balance Sheet (Statement of Financial Position), while OpEx goes in the Income Statement (Profit or Loss). 

  • Approval process

Capital expenses must typically be authorized by multiple layers of administration (including executive management), which will halt purchase until the clearance is granted. On the other hand, OpEx items are generally an easier process, as long as the item is covered through and budgeted for in the operating expense budget.

  • Upfront cost 

CapEx is an upfront cost, which has a value that gradually reduces over time. In contrast, there’s no upfront cost for OpEx. OpEx is the spending money on services & products necessary for day-to-day business operation, and it’s usually billed monthly or annually. 

Can you write off capital expenditures for tax purposes right away? 

In short, no. Unlike operational expenses, the IRS mostly doesn’t allow capital expenditures to be immediately deducted from your business profit in the year it incurred. Instead, they are gradually deducted from your business profit throughout the asset’s lifespan. 

For example, let’s say your business purchases $3,600 equipment, and the depreciation rate for that is two years or 24 months. This means that your company would deduct $150 every month and $1800 in a fiscal year. 

There are specific regulations that decide the number of years over which an asset is to be depreciated. Computer hardware, for example, is commonly depreciated over five years, while it is over seven years for office furniture.

Challenges with capital expenditures

CapEx is extremely vital to the future development of a business. With that being said, determining how much and how to allocate CapEx is not an easy decision at all. Here’s why: 

CapEx is unpredictable  

Due to its nature, the impact of CapEx decisions often prolongs into the future. The variety of present business activities is mostly the outcome of CapEx in the past. Similarly, current CapEx decisions will have a significant effect on the company in many years to come. 

But, no one can be sure of what the future holds and what lies ahead. 

Businesses making large investments in capital assets sometimes expect reliable & fruitful results. Such outcomes, however, are not guaranteed, and losses could occur. Both costs and profitability of CapEx are fraught with ambiguity. That’s why business owners should thoroughly account for risks during financial planning in order to reduce prospective losses, even though they cannot be totally eliminated.

CapEx is irreversible 

When a business wants to reverse capital expenditure, it will almost always suffer from losses. As much as capital equipment is tailored to an individual company’s requirements and demands, it’s difficult to resell, not to mention the paperwork process & time involved. 

For example, if your company buys new technology that rapidly becomes obsolete, you could hardly ‘undo’ that. Even worse, you might end up paying a big chunk of debt.

CapEx is difficult to measure  

The accounting process of realizing, measuring, and estimating capital expenditure may be extremely challenging. Some capital investment outcomes, such as boosting staff motivation and mental health, will not be shown on a balance sheet. Furthermore, calculating other related expenses is complicated, too. Let’s say your business is considering buying a brand new delivery van. You’d need to calculate the salary for a driver, insurance, fuel, along with other costs to determine the real cost of purchasing a new van.

Best practices to manage capital expenditure efficiently

Capital expenditures are often, because of their nature, significant in cost. Because of this, managing your CapEx properly and efficiently can save your business a lot of money and guarantee profitable and faster growth. 

Below are the five best practices for managing capital expenditure:   

  1. Be clear with your long-term business goals 

Once you’ve set defined, specific objectives for your business, you’ll have a solid framework to evaluate which CapEx proposals are worth investing in. If the scope of a CapEx project does not align with your long-term goals, the solution is simple: cancel it. 

When focusing on the big picture, consider where you want your company to be in five to ten years. Good capital expenditure planning & managing will offer a decade’s worth of value, helping you & your business achieve those long-term goals. 

  1. Standardize the approval process for CapEx requests

Regardless of your business size, every capital expenses request must undergo an evaluation process to get approval. However, sometimes this process can get lengthy or lack communication between departments, often leading to missing out on timely opportunities. 

Make sure to build a comprehensive guideline for your employees on the template of a CapEx request form, what analysis is required, or criteria to evaluate a project.

An efficient and systematic approval process will help you quickly determine if the CapEx is suitable with the company’s current portfolio or the return on investment (ROI) – weighed against both the costs and risks – is worthwhile.

  1.  Create a proper budget 

A solid budget will guarantee that you have the money to continue moving forward with capital projects while still having enough cash to run the business. As you plan your budget for the coming year, you must determine whether to use current cash to acquire capital or to incur debt on your balance sheet. 

It’s a good chance to figure out how your CapEx will influence your OpEx. For example, if you buy a new delivery van, be prepared to pay money on fuel and maintenance. You should also consider if it is financially wise to continue with CapEx. As manufacturing technologies continue to improve rapidly, leasing equipment or software (OpEx) may be more profitable than purchasing them.

  1. Carefully choosing financing options 

Your ultimate goal in financing CapEx should be to select the financing solution that will result in the most effective use of your working capital while also providing you with the most flexibility with asset ownership. Companies usually finance CapEx via two major methods:

  • Internal financing: the simplest way is to use your own cash. This also means you don’t need to pay any interest expenses. Yet, many companies don’t have enough cash on hand to pay for what they need. Also, you should consider the opportunity cost of paying large sums in a depreciating asset compared to other profitable ways to use that money.  
  • External financing: capital expenditures frequently necessitate the use of debt. Long-term debt comprises debt-servicing expenses such as interest, so companies must have enough income to cover their debts as well as their interest payments. While CapEx is a strong indicator for a business’s potential growth, too much debt can put the company in financial jeopardy.
  1. Use accounting software 

Using reliable & suitable accounting software to handle capital expenditures can reduce financial mistakes and errors. Failing to claim depreciation correctly can cost you much more than what it should be and might trigger an IRS audit

A great tool to support your accounting system and keep finances in order is Shoeboxed. Shoeboxed is a receipt scanner app that automatically digitizes & extracts important data from your receipts. This means your receipts are well-organized in the cloud, instead of taking up office space and your mind.

Conclusion

Capital expenditure (CapEx) refers to the funds for buying fixed assets or adding new value to the existing ones. It’s an essential driver in how a business develops and stays competitive in the market. 

Since managing CapEx is a highly complex process, fully understanding its nature or how to distinguish it from operational expenses is a must. 

Hopefully, this article has helped you do just that!