CapEx stands for capital expenditures, which is money used by an organization to purchase, improve, or sustain physical assets.
Commonly held physical assets include PP&E (property, plans, buildings, and equipment for running and sustaining the business).
In order to explain CapEx further I want to use a fictitious business to illustrate examples in a clear and concise way.
What is CapEx?
Firstly, imagine a company that makes jewelry - like engagement rings. In order to produce rings, the company needs basic materials (gold, diamonds, etc), equipment to turn these raw ingredients into final products, and labor.
Now imagine you own and operate this business.
As the owner of this company you decide that you will buy property (perhaps a warehouse for storing raw materials), equipment (such as a high temperature furnace to smelt gold), or fans to keep the showroom cool and comfortable.
What would you call this property and equipment? How would you account for them? To put it simply, this equipment is a capital expenditure.
In this case you are quite literally expending capital (money) in exchange for other types of assets to help the business grow.
And that is precisely what CapEx is.
Because buying the machinery, equipment, and property would help the business maintain or increase its operation, we classify these transactions as CapEx.
Another example is Goldspot Pens, a fountain pen store that sells bottled ink and fountain pens, who are investing in new, bigger warehouses for storing their fountain pens and ink. This costs more money, but increases Goldspot Pens' scope of economic performance in the future.
In this simple example, the choice to buy these future economically productive assets represents CapEx.
In summary, CapEx is the money an organization spends to buy, maintain, or improve its assets to increase its scope and economic performance.
How to Calculate CapEx
Now that you know what CapEx is, and are armed with an example of CapEx at a jewelry business, you might be curious how a company calculates CapEx in practice.
There is a simple equation: CapEx is equal to changes in PP&E added to Current Depreciation.
The formula: CapEx = ΔPP&E + Current Depreciation
Let’s break down these parts of the equation to clarify.
- CapEx: spending on business critical property or equipment or technology to grow the firm.
- ΔPP&E: changes in PP&E recorded on the balance sheet. If a firm buys a machine for $1M, for example, it will mark this machine in the PP&E section (usually under long term assets).
- Current Depreciation: a concept that captures the cost of the asset by the useful life of the asset.
Specifically, here are the steps to calculate Current Depreciation.
- Declare the useful life of the asset (10 years is a fair value to use).
- Subtract the salvage value of the asset (that is, at the end of year 10 the machine will be worth some value).
- Divide this value by the starting cost of the asset ($1,000,000)
In this example, let me show you what a depreciation table will yield. The asset starts at $1,000,000 on Day 1 but ends the depreciation cycle at $25,000.
|Year||Beginning Book Value||Depreciation Percent||Depreciation Amount||Accumulated Depreciation Amount||Ending Book Value|
Now that you know how to calculate depreciation, you can solve CapEx mathematically, using either a Direct or Indirect Method.
- Amount spent on asset #1
- Plus: Amount spent on asset #2
- Plus: Amount spent on asset #3
- Less: Value received for assets that were sold
- = Net CapEx
- PP&E Balance in the current period
- Less: PP&E balance in the previous period
- Plus: Depreciation in the current period
- = Net CapEx
If you bought an asset for $1,000,000 and sold it at the end of year 10 for $25,000 your Capital Expenditure would be: $1,000,000 - $25,000 = $975,000.
The Meaning of CapEx in Practice
When you decide to buy equipment today, you are doing so because you believe that the equipment will generate future economic benefits, or profits.
If you didn’t believe this, you likely would not have purchased the property, hardware, or equipment in the first place. Because CapEx is any type of expense that a company capitalizes, or shows on its balance sheet as an investment, you will need to justify how the purchase adds economic value to the firm's future.
For this reason, CapEx is considered a capitalized expenditure and not an expense.
This enables you, as the business owner, to match the economic benefits of the items you are buying with the costs in a given period of time.
If you were unable to match the purchase with economic benefits, you would treat the expenditure as an expense and not as an investment.
Many businesses, but not all, have CapEx.
Think about large companies like Google, AT&T, and Apple with large data centers, 5G networks, and fulfillment centers, respectively. These are all examples of CapEx.
These companies invest in these pieces of land, equipment, and machinery because each firm wants to secure a profitable future.
And without this CapEx, such a future would be harder to obtain.