Capital Expenditure

Capital Expenditure (CapEx)

What is Capital Expenditure?

Popularly called as CapEx, it means the expenditure incurred by an entity in maintaining, upgrading or purchasing non-current assets. Capital Expenditure is the amount spent by an entity on fixed assets with the usage of over one year and intangible assets.

Private Capital Expenditure is often used as a proxy for non-public investments. A higher level of CapEx may indicate that investment is higher, and the reverse is true. Therefore, CapEx by corporates serves as a proxy for private investments to some extent.

In accounting terms, it hits cash flows from investing activities along with movement in value or scale of assets. In the next year, the company will charge Depreciation and Amortisation on the asset, which will hit Income Statement.

Investment into intangible assets is also considered capital expenditure as patents, rights, trademarks, Knowhow, technology would provide benefits to the business over the years.

Fixed assets investments of businesses include the purchase of machinery, upgrade to machinery, incorporating a new plant. Moreover, CapEx being an expenditure is added to assets of business since it would deliver benefits over the future.

Revenue Expenditure vs CapEx

Revenue Expenditure of a company includes its operational expenses where the benefits to business from such expenditure would be short-term. It would include marketing expenses, distribution expense, employee costs etc. These expenditures are not capitalized and thus are booked in the profit and loss account.

Whereas CapEx by a company would deliver the benefits to the business for more than one year and allow the business to grow sustainably over the future. CapEx is often planned and budgeted for years and includes a higher level of evaluation by the management. The management often segregate the capex as growth or maintenance capex.

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Types of Capital Expenditures

Asset purchases: It means when an enterprise buys asset to benefit the business over the long run. A purchase of a new building would enable the business to increase its scale of products, and the new machinery installed in the building would manufacture products or aid in the manufacturing of products until the useful life of the asset.

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Asset improvements: It may include any upgradation to the existing asset base of the company, including a new software or technology, the addition of new part to improve output from existing assets, or maintenance of the assets held by the business.  

Intangible assets: Expense incurred by a business in developing or acquiring intangible assets, like patents or trademarks, are also capital expenditure since the expected value from the assets would be realised over the long-term.

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Why is CapEx important in investing?

Investment is necessary to grow a business, and capital expenditures often set the path for growth in businesses. Management seeks to deliver the best out of its resources, which may require further enhancements to fulfil the vision of the business.

CapEx seeks to derive further value for an enterprise through enhancements of existing assets, acquisition of new assets, adoption of new technology etc. It is an important decision that management of business seeks to take continuously and efficiently.

CapEx by companies depends on various factors, including business model, products, industry, size, scale. For instance, a large scale mining company like BHP Group Limited (ASX:BHP) requires a much higher level of CapEx compared to an online retailer like Kogan.com Limited (ASX:KGN).

But the expectations remain similar: to have a long-term sustainable revenue stream, enhancements to business models, or improvement in the profitability and sustainability of the business. Investors monitor capital decisions of firms very closely to ascertain short-term as well as long-term implications.

Since Capital Expenditure often includes large sums of money, it becomes imperative for investors to evaluate CapEx decisions of firms, sources of funds employed in CapEx, or expected liquidity of the business over the near-term. Moreover, investors seek to test the capital budgeting by the management.

However, there can be failures as well when the management expectations are not delivered by the past CapEx decisions. When things don’t turn as expected, it is likely that blame would be on management, but they would be appreciated when things turn out better than expected.

It is the reason why investors devote a decent time to study the management style of the Board. Management takes the ultimate call for Capital Expenditure plans of a business, and they must evaluate the investment through a sound cost-benefit approach.

The source of funds for the Capital Expenditure should also complement the long-term sustainability of the business. Companies fund their Capital Expenditure plans through debt or equity, and management must consider the appropriate source of funds to deliver expected benefits.

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Capital intensity and rise of Capital light business models

Capital intensity of a business depends on the type of business. Large businesses that require heavy assets or regular enhancements would have large Capital Expenditure plans and need for capital, but a software company with a similar scale of revenues may not need huge Capital Expenditure.

Capital intensive businesses come with long-term, a higher level of CapEx, and it is crucial for such business to manage CapEx plans. Companies engaged in Mining, construction business, equipment manufacturing, automobiles, energy, transports are considered as capital intensive business.

Capital light business models have grown popular over time due to high margins and profitability. Such business models are expected to deliver relatively higher levels of free cash flows to the company over time.

In asset-light businesses, the intensity of operational expenses or Revenue Expenditure is higher compared to CapEx. E-commerce companies like Amazon.com, Kogan.com Limited (ASX:KGN), Temple & Webster Group (ASX:TPW) are Capital light businesses.

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