Investments in Property, Plant and Equipment
Investments in Property, Plant and Equipment
A capital expenditure (“capex” for short) is the payment with either cash or credit to purchase goods or services that are capitalized on the balance sheet. To put it another way, it is any expenditure that is capitalized (i.e., not expensed directly on a company’s income statement) and is considered to be 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.
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 great 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.
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 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.
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.
Read more about the Capex Formula.
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 are a wide range of depreciation methods that can be used (straight line, declining balance, etc.) based on the preference of a 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):
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:
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.
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