What is a Capital Expenditure?
A capital expenditure (“CapEx” for short) is the payment with either cash or credit to purchase long term physical or fixed assets used in a business’s operations. The expenditures are capitalized (i.e., not expensed directly on a company’s income statement) on the balance sheet and are considered an investment by a company in expanding its business.
CapEx is important for companies to grow and maintain their business by investing in new property, plant, equipment (PP&E), products, and technology. Financial analysts and investors pay close attention to a company’s capital expenditures, as they do not initially appear on the income statement but can have a significant impact on cash flow.
When to Capitalize vs. Expense
The decision of whether to expense or capitalize an expenditure is based on how long the benefit of that spending is expected to last. If the benefit is less than 1 year, it must be expensed directly on the income statement. If the benefit is greater than 1 year, it must be capitalized as an asset on the balance sheet.
For example, the purchase of office supplies like printer ink and paper would not fall under-investing activities, but instead as an operating expense.
The purchase of a building, by contrast, would provide a benefit of more than 1 year and would thus be deemed a capital expenditure.
Learn more about when to capitalize on the IFRS website.
CapEx on the Cash Flow Statement
A capital expenditure can be found on a company’s cash flow statement, under “investing activities.” As you can see in the screenshot above from Amazon’s 2016 annual report (10-k), in 2016, they had $6,737 million of capital expenditure related to “purchase of property and equipment, including internal-use software and website development, net.”
Since this spending is considered an investment, it does not appear on the income statement.
CapEx on the Balance Sheet
CapEx flows from the cash flow statement to the balance sheet. Once capitalized, the value of the asset is slowly reduced over time (i.e., expensed) via depreciation expense.
How to Calculate Net Capital Expenditure
Net CapEx can be calculated either directly or indirectly. In the direct approach, an analyst must add up all of the individual items that make up the total expenditures, using a schedule or accounting software. In the indirect approach, the value can be inferred by looking at the value of assets on the balance sheet in conjunction with depreciation expense.
- Amount spent on asset #1
- Plus: Amount spent on asset #2
- Plus: Amount spent on asset #3
- Less: Value received for assets that were sold
- = Net CapEx
- PP&E Balance in the current period
- Less: PP&E balance in the previous period
- Plus: Depreciation in the current period
- = Net CapEx
Read more about the CapEx Formula.
Capital Expenditure and Depreciation
As a recap of the information outlined above, when an expenditure is capitalized, it is classified as an asset on the balance sheet. In order to move the asset off the balance sheet over time, it must be expensed and move through the income statement.
Accountants expense assets onto the income statement via depreciation. There is a wide range of depreciation methods that can be used (straight line, declining balance, etc.) based on the preference of the management team.
Over the life of an asset, total depreciation will be equal to the net capital expenditure. This means if a company regularly has more CapEx than depreciation, its asset base is growing.
Here is a guideline to see if a company is growing or shrinking (over time):
- CapEx > Depreciation = Growing Assets
- CapEx < Depreciation = Shrinking Assets
Capital Expenditure in Free Cash Flow
Free Cash Flow is one of the most important metrics in corporate finance. Analysts regularly evaluate a company’s ability to generate cash flow and consider it one of the main ways a company can create shareholder value.
The formula for Free Cash Flow (FCF) is:
FCF = Cash from Operations – Capital Expenditures
CapEx in Valuation
In financial modeling and valuation, an analyst will build a DCF model to determine the net present value (NPV) of the business. The most common approach is to calculate a company’s unlevered free cash flow (free cash flow to the firm) and discount it back to the present using the weighted average cost of capital (WACC).
Below is a screenshot of a financial model calculating unlevered free cash flow, which is impacted by capital expenditures.
Source: CFI’s Financial Modeling Course.
Thank you for reading CFI’s guide to Capital Expenditures. To keep advancing your career, these additional CFI resources will be useful: