# Capex – what it is and why it’s important for long-term investments

INDEX

Capex, short for “capital expenditure,” refers to the funds used by a company to acquire, upgrade, and maintain physical assets such as property, industrial buildings, or equipment. This type of expenditure is often used for significant investments in the business and is intended to benefit the company over a long period, rather than just the current fiscal year.

Read on to find out what it is, what it means, and how to calculate it, among others.

## Understanding capex

Capex refers to the funds used by a business to acquire, upgrade, and maintain physical assets such as property, buildings, technology, or equipment. It's a key part of a company's investment in its future operations and growth.

Capex includes spending on new assets that will provide utility to the business over several years, rather than just the current period. This type of expenditure is crucial for a company’s long-term success and expansion, as it often leads to increased capacity, improved efficiency, or expansion into new markets. In financial statements, capex is reflected in the balance sheet as an asset and depreciated over the life of the asset.

### Capex formula

Calculating capital expenditures (capex) involves determining the total amount of money a company spends on acquiring or improving long-term assets. One of the capex formulae is:

Capex = PP&E + Current Depreciation

Where:

PP&E = changes in Property, Plant, and Equipment (located in the balance sheet)

Essentially, to calculate capex, you need to locate the changes in PP&E and depreciation (current period).

The change in PP&E represents what the company has invested in new fixed assets. On the other hand, in the income statement, we find the amortisation of the tangible assets.

## What does capex mean?

Capex is important for a company and its investors for several reasons. First, capex is what allows the company to improve its productive capacity and competitiveness in the long term, which can increase its profitability and value for investors.

For example, a company that acquires more efficient machinery or expands its plant can increase its production and reduce its costs, which will allow it to obtain greater profits and attract more investors.

A high capex often indicates that a company is investing in its future growth and expansion. This can include acquiring new technology, expanding facilities, or entering new markets. Investing in new assets can give a company a competitive edge, such as through more efficient production methods or superior technology. Although expensive initially, these investments can lead to higher profits in the long run.

On the other hand, a high capex also has several drawbacks. Large capital expenditures can strain a company's finances, especially if they lead to significant debt or use up a substantial portion of cash reserves. Also, not all capital investments yield positive returns. There's a risk that the investment may not pay off as expected, which can be detrimental. Finally, a high capex can lead to reduced cash flow in the short term, which might affect the company’s ability to manage day-to-day operations or invest in other areas.

## Types of capex

There are multiple types of capex, depending on the nature of the investment and the purpose it serves for the business. Some of the main ones are:

• Expansion capex: This involves spending on acquiring new assets or expanding existing ones to increase the company's production capacity or to enter new markets. It's focused on growth and includes investments like building new facilities, expanding to new locations, or increasing production capabilities.
• Maintenance capex: This refers to the expenditure required to maintain the current operational capacity of the company. It includes costs for repairing and replacing existing equipment or infrastructure to ensure smooth and uninterrupted business operations.

## Difference between capex and opex

Capital Expenditure (capex) and Operating Expenditure (opex) are two primary types of business expenses, but they differ in nature, purpose, and the way they are accounted for in financial statements.

Opex covers the day-to-day costs associated with running a business. These expenses are for maintaining and operating the existing assets and business operations. Examples include salaries, rent, utilities, and routine repairs and maintenance.

Capex refers to the funds used by a company to acquire or upgrade physical assets such as property, equipment, or industrial buildings. This type of expenditure is aimed at future benefits. It is an investment in the business that is expected to provide utility over several years.

Another point to take into account is tax treatment. Capex is a cost recovered over time through depreciation or amortisation and thus provides a tax shield over several years. Opex costs are generally fully deductible in the year they are incurred, providing an immediate tax benefit.

## What types of investment projects are usually financed with Capex and which with Opex?

Investment projects are usually financed with Capex (capital expenditure) or with Opex (operating expenditure), depending on the type of investment being developed.

Some examples of investment projects that are usually financed with Capex include:

• Acquisition of machinery, equipment, or buildings.
• Significant improvements or upgrades to existing assets, such as retrofitting a factory with new technology or expanding a facility.
• Large-scale technology implementations, like a new manufacturing system or IT infrastructure, are typically funded as capex.
• Long-term projects such as research and development of new products or services can be capitalised if they meet certain criteria.

Some examples of investment projects that are usually financed with Opex include:

• Regular upkeep of existing assets and facilities to ensure smooth operations.
• Day-to-day expenses such as salaries, utilities, rent, office supplies, and software subscriptions.
• Ongoing promotional activities and campaigns that do not have long-term capital benefits.
• Costs related to employee training, workshops, and other skill development programs.
• Smaller-scale or short-term research activities that are part of regular business operations.

## Capex ratios

Here are some examples and their meaning:

• Capex/Non-Current Asset Ratio: This ratio assesses the impact of capital expenditures on the size of the company's non-current (long-term) assets. A higher ratio may indicate significant investment in long-term assets relative to their existing value.
• Capex/Amortisation Ratio: A high ratio suggests that a significant portion of capex is allocated towards expanding productive capacity or acquiring new assets. A low ratio indicates that more capex is likely being spent on maintenance and upkeep of existing assets.
• Capex to Net Profit, EBITDA, or Sales Ratios: These ratios provide insight into how much the company is investing in capital assets relative to its earnings or sales. They can help in understanding the efficiency of capex in generating profits or contributing to business operations. For example, if the Capex is £14,500 and the Net Profit is £5,000, the Capex to Net Profit ratio is 2.9. This means that for every £1 of Net Profit, the company spends £2.9 on Capex, which could be concerning (i.e., unsustainable spending, but of the high capex leads to significant revenue and profit growth in the future, it might be justified.)

## Example of calculating capex

Let's calculate capex for two fictitious companies, ABC and CBA.

Company ABC:

• Previous Year PP&E: £20,000
• Current Year PP&E: £25,000
• Depreciation for Current Year: £3,000
• Calculated CAPEX: £25,000−£20,000+£3,000=£8,000

Company CBA:

• Previous Year PP&E: £15,000
• Current Year PP&E: £18,000
• Depreciation for Current Year: £2,000
• Calculated CAPEX: £18,000−£15,000+£2,000=£5,000

Company ABC has a higher CAPEX of £8,000 compared to Company CBA's £5,000. This indicates that ABC is potentially investing more in acquiring or upgrading its physical assets. The higher CAPEX for ABC might suggest a more aggressive growth strategy, larger scale operations, or a greater focus on expanding or updating its assets.

However, without additional context such as the size of the companies, their industries, or the specific purposes of these expenditures, it's difficult to conclude whether a higher or lower CAPEX is more advantageous. Each company's CAPEX needs to be evaluated in the context of its overall financial health, industry standards, and long-term strategy.

## Summary

Capital Expenditure (capex) is a critical financial metric that represents a company's investment in acquiring or upgrading long-term physical assets, essential for future growth and operational efficiency. The calculation, interpretation, and comparison of capex, as demonstrated through various examples above, provide insights into a company's financial health, investment strategy, and its balance between maintaining operations and pursuing growth opportunities.

## FAQs

### How does capex affect a company's cash flow?

Capex can significantly impact a company's cash flow, as it represents large sums of money spent on acquiring or upgrading assets. This outflow of cash reduces the amount available for other uses in the short term but is expected to generate returns over the long term.

### Is there a ‘good' level of capex for a company?

There's no one-size-fits-all ‘good' level of capex, as it depends on the industry, the stage of the company, and its strategic goals. A good level of capex is one that aligns with the company's long-term strategy and is sustainable given its financial situation.

### How does capex differ in various industries?

Capex varies greatly across industries. Industries like manufacturing or utilities typically have higher capex due to the nature of their business requiring significant investment in physical assets. In contrast, service-oriented industries like software may have lower capex.