What it means
Businesses spend money in two broad ways. Day-to-day running costs, like wages and electricity, are expensed in the period they occur.
Capital expenditure buys things that will help the business for several years, so the cost is capitalised, which means it is added to the balance sheet. Once capitalised, the cost is gradually written off through depreciation, or amortisation for intangible assets, over the asset's useful life.
This matches the cost to the years that benefit from the asset. A $120,000 machine that lasts six years is charged at $20,000 a year, for example, if straight-line depreciation is used.
The line between capex and ordinary repairs matters. Spending that extends an asset's life or improves its capacity is generally capital, while routine maintenance that keeps it working is an expense.
Companies usually set a minimum cost threshold below which items are expensed immediately. Capex is important for assessing a business.
Investors look at it to see whether a company is investing for growth or just maintaining its asset base. Free cash flow, a common measure of cash available to owners, is typically operating cash flow minus capex.
Capex can be split into maintenance capex, which keeps existing capacity going, and growth capex, which adds new capacity. A firm spending far less than its depreciation for a long time may be underinvesting, which can flatter profits for a while but hurts later.
Because capex is large and lumpy, it needs planning. Finance teams build capital budgets, arrange funding through cash, loans or leases, and track project spending against approval.
In practice
Real-world examples
Example 1
A bakery buys a new $40,000 oven. The cost is capitalised and depreciated over ten years at $4,000 a year. Repairs to the old oven's door seal, costing $300, are expensed immediately. The bakery's accountant keeps a list of what is capitalised.
Example 2
A trucking company spends $900,000 on five new trucks to expand its routes. Investors read this as growth capex and ask about the expected revenue from the new routes. The CFO presents the plan and the expected return.
Example 3
A software company capitalises $1,200,000 of qualifying development costs for a new platform, following its accounting policy. The cost is amortised over the expected life of the product. The company discloses the amounts in its notes. Auditors check that the costs meet the conditions for capitalisation.
Think of it
Capital expenditure is like buying a house versus renting an apartment. You're making a major investment that will provide value for years, not just paying for immediate use.
Formula
Calculation
Capital expenditure = Closing net fixed assets - Opening net fixed assets + Depreciation for the period
Suppose a company's net fixed assets were $500,000 at the start of the year and $560,000 at the end, and depreciation for the year was $70,000.
Change in net fixed assets = 560,000 - 500,000 = $60,000.
Capex = 60,000 + 70,000 = $130,000. This assumes there were no disposals or revaluations during the year.Case study
Seen in the real world
Harlow Packaging is a fictional manufacturer that cut its capital spending for three years to protect profits. Its depreciation charge was $2,000,000 a year, but capex averaged only $900,000. Reported earnings looked healthy, and the board was pleased with the margins.
A new CFO noticed the gap and arranged an equipment audit. The illustrative findings showed that several machines were close to the end of their lives, with rising breakdowns and rising repair bills. The company had been underinvesting.
The CFO proposed a three-year capex plan of $3,500,000 a year, funded partly by a bank loan, and explained to the board that profits would fall in the short term. The plan restored reliability and gave the company a base for growth. The board also asked for an annual report comparing capex with depreciation, split between maintenance and growth spending, so that a long period of underinvestment would be spotted much earlier in future.
Watch out
Common mistakes
- Expensing everything immediately. Long-lasting assets should be capitalised and depreciated over their life, so that each year carries a fair share of the cost.
- Capitalising routine repairs. Maintenance that only keeps an asset working is an expense, and treating it as capex inflates profit in the short term.
- Ignoring capex when judging profitability. A firm can show good profit while underinvesting in its assets, which damages performance in later years.
Questions
People also ask
What is the difference between capex and opex?
Capex buys long-lasting assets and is capitalised, while opex covers day-to-day running costs and is expensed. Moving an item from one to the other changes reported profit.
How does capex affect cash flow?
It is a cash outflow when paid, but it reaches the profit and loss account only gradually through depreciation. This is why profit and cash can look very different in a heavy investment year.
What is maintenance capex?
It is spending needed to keep existing capacity running, as opposed to growth capex that adds new capacity. Investors often value a business on the basis of its free cash flow after maintenance capex.
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