The physical, fixed assets lay the foundation for the business. They enable the production and manufacturing of the business’ main offerings and facilitate the overall functioning of the business.
Fixed assets comprise a major part of the business, and naturally, account for most of the initial business expenses. The costs incurred during the purchase and maintenance of fixed assets are known as capital expenditures.
Capital expenditures (Capex full form) facilitate core business activities. In this guide, we will discuss capital expenses in depth. We will learn about the types, importance, characteristics, and issues involved in capital investments.
What is capital expenditure?
Capital expenditure is the sum total of all money spent to obtain, upgrade, manage, fix or maintain physical assets of the company such as plants, land, machinery, technology or buildings. They are used during the conception of the business, and later during the start of a new project, branch, or investment.
A business decides to incur capital expenses when they are planning to increase its asset value, expand the range of operations, increase profit-generating activities, and eventually, derive more benefit from the assets.
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What is capital expenditure in accounting?
Capital expenses appear on the balance sheet and not the income statement of a business. The capital expenditure amount is calculated as an asset on the balance sheet.
Fixed assets have a depreciation factor. This means that every year their effective value reduces by a certain percentage. This depreciation cost is then recorded on the income statement as an expense and reduces the overall profit of the year.
For example, if a company buys a set of computer systems for its employees, the cost of the computers will be recorded under the balance sheet. These computers will have a certain depreciation value. Let’s say, their total depreciation amount is 10,000 INR per year. For the years that follow the purchase of computers, the income statement will report a depreciation expense of 10,000 rupees.
Capital expenses do affect the income statement of the company. But it does not happen in the year of their purchase, but in the following years as per the depreciation value of the assets obtained.
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Types of capital expenditure
Let’s discuss a few types of capital expenditures in detail.
1. Buildings, land, and property
The cost of buying a building, property, or any piece of real estate is a capital expense since these assets are relevant to the business for many years. Maintaining and repairing these buildings are also capital expenses. These are long-term assets and require a high level of commitment and investment.
2. Upgrades to machinery
The machinery and equipment used to develop products are unavoidable expenses for businesses. This equipment and its needs evolve with time and the changes in technology. Any upgrades made to existing machinery are capital expenditures.
3. Software infrastructure
Nowadays, it has become impossible for many businesses to function without certain software. Whether it is management software or a cyber security infrastructure, digital solutions form the backbone of many administrative processes, especially for large businesses. The cost of purchase, installation, maintenance, and upgradation of this software is a capital expenditure.
4. Computer hardware
The cost incurred from buying computer hardware like desktops, laptops, servers, etc. is also classified as a capital expense.
Certain companies need to own multiple vehicles to carry out their operations. For example, delivery and shipping companies heavily depend on vehicles for transportation. The cost of these vehicles then becomes a capital expense.
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Capital expenditure examples
Here are a few examples of capital expenses.
- Machinery and capital equipment
- Company vehicles
Importance of capital expenditure
Capital expenses are important because they help organizations set up operations. Without capital investments, a business cannot start functioning. Also, post set-up and launch, capital expenses help scale up the company’s operations and initiate growth.
Here is a list of functions that capital expenses facilitate-
- Acquisitions – Capital expenses facilitate the acquisition of property, machinery, or equipment.
- Expansion – Expansion expenses facilitate the improvement of facilities, development of infrastructure, and increase in existing assets and physical capacity.
- Set-up and launch – Capital expenses help organizations buy the property and machinery needed to set up the business.
- Growth- Capital expenditures help scale up the organization with new equipment additions and upgrades. They are used to accelerate business operations and increase efficiency.
Characteristics of capital expenditures
As discussed above, one of the most important things to consider while investing in a fixed asset is that its value will depreciate over time. Depreciation continues throughout the life of a fixed asset and brings the value down every year.
2. Difficult to measure
Measuring, calculating, and accounting for capital expenses and their depreciation value can be tricky.
3. Long-term investments
Costs related to fixed assets are long-term investments. Their benefits and costs are stretched over the years.
Issues with Capital Expenditures
As discussed in the section above, there are certain risks associated with capital expenses and budgeting.
1. Risk and unpredictability
Capital investments are high-value investments and account for a very large part of the business’s total initial spend. However, companies gladly make these investments because they believe that fixed assets are gonna yield the desired results in the long run.
However, nothing is a given in the business world and every investment comes with a risk. Capital expenditures also run the risk of losses. Hence, while making the initial financial plan, the finance leaders should ensure that they have accounted for all the probable risks and possible losses to mitigate the effect they will have on the business.
2. High-initial costs
Companies use fixed assets for a long time. It hence goes without saying that these assets have to be apt for extended company use without a significant decline in performance. Hence, fixed assets have considerably high costs.
Capital expenses also increase with the increase in time, especially the costs associated with maintaining and upgrading fixed assets.
It is extremely important for businesses to do due diligence and need analysis before buying a major fixed asset. This is because fixed assets are not only high-value expenses but also because they are difficult to reverse. Additionally, many capital assets are tailor-made according to a company’s needs. This makes it almost impossible for businesses to replace them with other assets.
How to calculate capital expenditures?
Follow these steps to calculate capital expenditure.
Step 1: Cashflow statement
You can find CapEx in the cash flow statement of the company. Cash outflow from investing activities is capital expenditure. The representation of capital expenditure on financial statements may differ based on the company. Sometimes, it is listed as ‘capital spending,’ ‘PP&E expense’ or ‘acquisition expense.’
You can also learn about capital expenses by studying the income statement and balance sheet.
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Step 2: Deduct fixed assets
Find the depreciation amount for assets on the income statement for a specific period of time. Find the period’s plant, equipment, or property line-item balance. Now find the former period’s PP&E balance and calculate the difference between the current and previous balances.
Step 3: Add the difference to depreciation
Add the difference between the current and past PP&E balance to the depreciation amount of the current period. You will then get the current- accounting period capital expenditure.
Capital expense management – Best practices
1. Plan ahead
It is very important for finance officers to prepare a budget for capital expenses ahead of making any purchases. Since capital expenses are costly, irreversible, and irreplaceable by their very nature, even small decision-making missteps can lead to huge losses.
Before investing in a new fixed asset, make sure that the scope and expectations of the asset are realistic. Work out as many details as possible including exactly how many resources the asset will require to become functional and profitable. This includes not only monetary considerations but also materials, services, and manpower.
2. Decide how you will buy the asset
Buying a capital asset requires considerable funds. If you cannot immediately afford an asset, you can borrow money to purchase it. Assess your company’s financial standing and the urgency for a particular asset before making the decision.
3. Use the right budgeting and accounting tools
Adopt efficient budgeting and accounting tools for capital budgeting that complement your capital expense policies. Accuracy of data is crucial while managing any kind of expense. Hence, investing in budgeting or spend management software will be a smart move for capital expense management.
What is capital expense management software?
Capital expenditure management software automates the planning and budgetary functions of complex CapEx decisions. They tell you how your capital investment decisions can affect your organization in the long run.
Capital expenditure management software can also provide a centralized platform for communicating with stakeholders. For example, a collaborative platform for coordinating with advisors, bankers, investors, etc.
Here are five capital expenditure management software.
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Empower your expense policy with Happay
Capital expenses are one of the biggest investments that a company makes. It is hence imperative for the decision-makers to understand how capital expenses function in the long term.
The first step to capital expense management is devising a policy that details the steps required before new investments. The next step is to pair up that policy with a platform to support it and ensure compliance.
Happay is an end-to-end expense management software that comes with advanced analytics. It allows 100% visibility into employee spend behavior and it can allow you to access the information needed to create budgets. The base-level spend visibility translates into high-level and capital-expense budget decisions.
Quick Read: Travel and Expense Policy
Capital expenses aid the conception, expansion, and growth of a business. They are generally big investments with high risks. Before investing in capital assets, it is crucial to research the assets and do a cost-benefit analysis for both the long and short term. This will not only safeguard you against loss but also ensure the future growth of your business.
1. What does CapEx mean?
CapEx stands for capital expenses.
2. What is useful life in capital expenses?
“Useful life” of a capital expense is the number of years for which it remains usable before reaching complete accumulated depreciation.
3. How are capital expenses different from operating expenses?
Capital expenses facilitate the purchase of long-term capital assets like land, building, intellectual property, etc.
Operating expenses, also known as operating costs or opex, pay for the day-to-day operations of the company and are majorly recurring like rent, electricity, sanitation, etc.
4. Can capital expenses be intangible assets?
Yes, costs like intellectual property expenses, patent costs, etc. are intangible capital expenses.
5. Is the cost of raw materials a capital expense?
When raw materials are used for the manufacturing or production of capital assets, they are included in capital expenses.