Capital expenditure refers to money that a firm employs to purchase physical assets. This can also be used to upgrade existing assets. These can include items such as equipment, industrial buildings, and property. It is also known as CapEx. Companies often use this CapEx to make new investments or to begin a new project.
Other corporations utilize capital expenditures to build up their operations’ size and scale. Such expenditures can cover many different items like buying a new piece of equipment, fixing the roof on a company building, or constructing a new factory for the company.
Accounting procedures utilize this capital expenditure concept regularly. Expenses will be labeled as CapEx if the item the company buys is a new purchase of a capital asset. They also fall under this category when the purchase is some type of investment that extends the practical life of an already owned capital asset.
When a purchase falls under the capital expenditure’s category, the accounting department will be required to capitalize it. They do this when the fixed cost of the purchase is spread out over the asset’s useful life. In other cases, the money they spend will only keep the capital item in its present condition. For these scenarios the company and accountants may simply deduct the entire expense for the year in which they spend the money.
Different industries will employ varying levels of capital expenditures. Some use very little, while others are more capital intensive. Among the most intensive capital industries in the world are the exploration and production of energy such as oil or natural gas, manufacturing businesses, telecommunications, and electricity, gas, and water utilities.
It is important to not confuse capital expenditures with other ideas like operating expenses, known as OPEX, or revenue expenditures. Operating and revenue expenses are money that companies pay to cover the daily cost of running the business. Revenue expenses are different from CapEx in another significant way. The former can be completely deducted from taxes in the year in which the company spends them.
Capital expenditures can be used to help come up with the relative value of a company also. Cash flow to capital expenditure ratio is one such measure. It is commonly referred to as CF/CapEx. This explains the ability of a company to purchase assets for long term use by utilizing its free cash flow. This ratio commonly goes up and down for businesses as they engage in cycles of small capital versus large capital expenses.
Ideally a business wants to have a higher multiple in this ratio. Higher numbers signify that the company is in a position of solid financial health and strength. This is because firms that possess the financial capabilities to invest in their future with capital expenditures can expand with greater ease and flexibility.
Cash flows to capital expenditures are ratios that are specific to every industry. Each segment’s ratio will be different. This means that the ratio of one company in one business should not be compared to a second company in another industry. Instead, the ratio is only useful for comparison when two companies that possess comparable CapEx requirements are examined. Comparing various CapEx ratios from two oil firms or utility companies makes sense. Holding up the CapEx ratios of an oil company or telecom firm against a consulting business or advertising agency does not.
The higher a company’s capital expenditure is, the lower its other measures of financial health may be. As an example, firms with high CapEx will often show less free cash flow to equity.