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Meaning of capital expenditure
A capital expenditure (in short, CapEx) means money spent by a business or any organisation to acquire or maintain any fixed assets and intangible assets used in business operations. The expenditure is capitalised, which means it is not directly shown in the company’s income statements which are not for day to day expenses, as it is an investment made by the company in expanding its operations.
Capital expenditure helps in understanding whether an asset offers an impressive rate of return or not. In this way, the company could maintain its existing resources and have the capital to invest in expanding business, for example, investing in plants, machinery, equipment, buildings etc.
Importance of capital expenditure
Capital expenditure helps to bring the attention of business stakeholders such as investors, employees, customers, and other parties to the company. They are not necessarily shown in the company’s income statements but can have a significant impact on the company’s cash flow statement.
It also helps the company acquire, upgrade, and maintain physical assets, which is often used to undertake new investments and projects.
Capital expenditure has effects in the long and short-run as in current time the capital expenditures made in the past largely governs it. Similarly, current CapEx provides a basis to make decisions for future activities.
If spent wisely, the amount of CapEx will also help the company reap its benefits for a more extended period.
Items that are included in the CapEx are as follows:
Initiating or acquiring of new business
Acquiring fixed or intangible assets
Improving current assets to improve their applicability
Re-conditioning the existing asset to enhance the performance of the business
Preparing an asset to be used in business operations
Capitalisation or expense?
The question which usually comes to the mind of everyone is which costs incurred should be capitalised or expensed. The cost, whose benefit will last less than one year, will be directly expensed to the business’s income statement. In contrast, a cost whose benefit is more significant than the tenure of one year will be capitalised in the company’s balance sheet in the form of assets.
For instance, the purchase of utilities (electricity, gas, water) would fall under operating expenses and not under investing activities. In contrast, the purchase of machinery, on the contrary, would provide a benefit of more than one year accounting year and thus will fall into capital expenditure.
Thus, the operating expense or operational cost is the counterpart of capital expenditure.
Accounting ruling for capital expenditure
Capital expenditure can be found in the under ‘investing activities’ under the cash flow statement. As this spending is considered an investment, it is not included in the company’s income statement.
Secondly, capital expenditure is shown as an asset in the balance sheet. It is written off in several years as a depreciation expense, beginning on the date at which the items have been purchased.
Moreover, capital expenditure creates or adds basis to the asset or the property, which, once adjusted, will determine the tax liability in the event of sale and transfer.
How to calculate capital expenditure?
First, we need to locate a company’s financial statements whose capital expenditure we want to calculate. Moreover, if the company is held public, then the data will be readily available on the website of SEBI (Securities and Exchange Board of India).
Second, locate depreciation and amortisation on the income statement.
Hit on to the current year PP&E (property, plant, & equipment) and previous year PP&E as given in the balance sheet.
Find out the net change in PP&E between the previous and current years. Now use the formula given below to arrive at calculating the capital expenditure.
CapEx= addition of net change in PP&E + depreciation of current year.
Now let us take an example to understand this concept better:
Example: Suppose Ramesh owns a company that manufactures a car. He decided to spend money on the new equipment and an expansion. He then decided to calculate his company’s capital expenditures for that year. We determine the following information:
Depreciation= ₹18000
PP&E at the end of 2020= ₹60000
PP&E at the beginning of 2020= ₹45000
Given these values, we can calculate capital expenditure.
Solution: Start by subtracting the value of PP&E at the beginning of 2020 (₹45000) from the PP&E at the end of 2020 (₹60000). This will give us a change in PP&E of ₹15000. Now add this value to the depreciation expense (₹18000). This will result in a capital expenditure of ₹33,000 for the year 2020.
Conclusion
CapEx is the amount corporations or businesses spend to purchase, maintain, and improve fixed assets and in some cases intangible assets as well. It helps the business to undertake new projects or enhance the existing ones. Also, we can locate it on the company’s cash flow statement under “investing activities”. We can find it negative in the cash flow statement as, along with investment, it is also capital expenditure. So it is found as an asset in the company’s balance sheet. Moreover, calculating it can help the company acquire, improve, and maintain the assets and help to improve its applicability in the business. Therefore, calculating and investing is very vital part of any business.
