Capital expenditures, otherwise known as CAPEX, are mentioned in startup board meetings all the time. It’s definitely a fundamental term to understand when dealing with startup accounting.
Capital Expenditures Depend On Your Startup Industry
The importance of your capital expenditures depends a little bit on the type of startup you are running. For example, if you’re a manufacturing or cleantech company, which involves heavy, physical equipment, CAPEX is your number one ingredient in the business.
CAPEX are Investments
At a high level, capital expenditures are investments that a startup makes in things like:
- Fixed assets
- Property
- Equipment
- Computers/Physical Technology
- Furniture
- And, often, software can be CAPEX too
These are big investments. Whether your startup is building robots, or working in cleantech that’s capturing CO2 from the environment, you’re going have to have a building in which to house your machines and, obviously, you’re going to have the machines and all of the parts that go into them. These are all capital expenditures.
The impact of CAPEX on financial statements
Capital expenditures have a significant impact on a company’s financial statements, affecting the balance sheet, income statement, and cash flow statement in different ways:
- Balance Sheet: When a company makes a capital expenditure, it increases the value of its fixed assets or capital assets on the balance sheet. This reflects the company’s investment in long-term resources.
- Income Statement: Capital expenditures are not immediately expensed on the income statement. Instead, they are depreciated over time, with the depreciation expense appearing on the income statement each year.
- Cash Flow Statement: The full amount of a capital expenditure is reflected in the investing activities section of the company’s cash flow statement in the year the expense is incurred. This shows the immediate impact on the company’s cash position.
Understanding how capital expenditures affect these financial statements is crucial for accurately assessing a company’s financial health and future prospects.
Capital Expenditures on the Balance Sheet
Now, capital expenditures are interesting in the accounting world because they get treated slightly differently from regular operating expenses. Operating expenses are things such as:
- Employee salaries
- Food/Catering
- Hotels
- Travel
If capital expenditures are over $2500, they are actually “capitalized” on the balance sheet. This means they are put in an asset count on your balance sheet and you recognize the expense. You amortize or depreciate those fixed assets over time. The length of time you depreciate those fixed assets depends on what they are and what the IRS’s guidance is.
Usually that’s about two to five years. It’s the kind of thing that gets washed out on your tax return and, often, there’s some adjusted journal entries at the end of the year to make sure that the amortization/depreciation schedules match your tax returns.
So when you make capital expenditures they will be reflected on your balance sheet as an asset, and that asset’s going to be reduced every year by the annual depreciation and amortization that’s applicable to that asset.
CAPEX on the Cash Flow Statement
As well as being on the balance sheet, CAPEX is also reflected on your cash flow statement as it falls under investing activities. The structure of the cash flow statement will generally go as follows:
- The first group to appear on a cash flow statement will be operating activities. These are usually items that influence your net income, but include other operating items that impact cash flow but that don’t appear on the income statement. These non-income statement items are ones that can be seen as changes on your balance sheet, such as increases in accounts payable or other net working capital items.
- Then there will be some add-backs, like working capital.
- Next will be other kinds of balance sheet accounts that may fluctuate to get to your cash flow provided from operating activities.
- Finally you’ll have investing activities, which is what capital expenditures fall under. Again, you’ll see those big cash outflows being reflected there, along with depreciation offsetting it.
Your cash flow statement is a very easy way for investors to see what’s actually happening in your startup’s finances. They look at the cash flow statement quite a bit when they’re looking at capital expenditures.
Net CAPEX and free cash flow
Net CAPEX and its relationship to free cash flow are important concepts for investors and financial analysts:
Net CAPEX = Gross Capital Expenditures - Depreciation Expense
Net CAPEX represents the actual cash outlay for capital investments after accounting for the depreciation of existing assets. This figure is crucial in calculating a company’s free cash flow:
Free Cash Flow = Operating Cash Flow - Net CAPEX
Free cash flow is a key metric that investors use to evaluate a company’s financial health and ability to generate cash beyond what is required to maintain its asset base. A company with high free cash flow relative to its capital expenditures is often seen as financially strong and well-positioned for future growth.
CAPEX and the income statement
The income statement is often the 1st, and most important, financial statement that founders and investors look at - but CAPEX doesn’t impact this financial statement in quite the same was as it does others. A capital expenditure is not an operating expense, so it doesn’t hit the income statement. But, while a capital expenditure is not directly reported on the income statement, it does have a significant indirect impact:
- Depreciation Expense: The cost of capital expenditures is spread out over time through depreciation. This depreciation expense appears on the income statement, reducing the company’s reported profit.
- Interest Expense: If a company finances its capital expenditures through debt, the resulting interest payments are recorded as an expense on the income statement.
- Maintenance Costs: Capital assets acquired through CAPEX often require ongoing maintenance, which is expensed on the income statement.
- Revenue Generation: Although not a direct entry, CAPEX can lead to increased revenue over time as new assets contribute to the company’s productive capacity.
- Tax Implications: Depreciation expense from capital expenditures can reduce taxable income, affecting the income tax expense on the income statement.
Understanding the relationship between capital expenditures and the income statement is crucial for accurate financial analysis and forecasting. While the full cost of CAPEX isn’t immediately visible on the income statement, its effects are felt over the asset’s useful life through these various channels.
Debt Financing for CAPEX Heavy Companies
If you are a heavy machinery/heavy asset kind of business, you have to be able to talk to your VCs accordingly. You need them to understand that these are large investments and that companies of this kind are typically going to need a lot more venture capital than, say, a software company or a consumer packaged goods (CPG) company, for example. If your startup requires large machinery and other assets, you will most likely use debt financing to augment your venture capital equity.
VCs who invest in CAPEX-heavy companies are typically very close with a lot of lending firms. They know them and they can make referrals. They have them on their speed dial as it were, and that debt is actually a very important ingredient if you’re running a capital-intensive startup. You will have to finance a lot of that stuff. Debt has a lower cost of capital than equity, and if you use too much equity to finance capital purchases, you’re probably experiencing a little bit more dilution than you need to. Debt helps mitigate some of the dilution.
So when you’re in a board meeting, or you’re pitching your capital intensive business, please remember that you may have to finance yourself in a slightly different way. The financial combination for your startup will be different. You should also know that the accounting treatment is going to be different. A lot of those assets will be capitalized on the balance sheet and they will be reflected on the investing activities portion of the cash flow statement.
Finally, only annual depreciation and amortization will be shown on your income statement as an expense.
Capex vs. operating expenses
It’s essential to differentiate between CAPEX and operating expenses (OPEX). Operating expenses are the day-to-day costs required to run the business, such as:
- Employee salaries
- Office supplies
- Travel expenses
- Utilities
Unlike CAPEX, operating expenses are fully deducted in the income statement in the period they are incurred, without being capitalized.
Capital expenditures and working capital
While capital expenditures primarily involve long-term assets, they can also have a significant impact on a company’s working capital. Working capital, defined as current assets minus current liabilities, represents the capital available for day-to-day operations.
When a company makes substantial capital expenditures, it can affect working capital in several ways:
- Cash Reduction: Large capital expenditures can deplete cash reserves, potentially reducing working capital.
- Inventory Increases: Some capital expenditures, particularly in manufacturing, may lead to increased inventory levels, affecting net working capital. Note that capex is not inventory - but we have seen that many companies that invest in manufacturing equipment also end up creating more inventory - both finished goods, and raw materials that are used to produce that inventory. This makes sense, because if you invest to increase your ability to manufacture, then you are going to need more materials and create more end product. This can be a major working capital cash user.
- Accounts Payable: If capital expenditures are financed through supplier credit, it can temporarily increase accounts payable and affect working capital.
- Long-term Financing: Using long-term debt to finance capital expenditures can actually improve working capital by increasing cash without affecting current liabilities. This is basically a loan (although your accountant may specific, technical ways they account for this type of financing).
Understanding the relationship between capital expenditures and working capital is crucial for maintaining a healthy balance between long-term investments and short-term operational needs.
Capital Expenditures and Cash Runway
With CAPEX and the cash runway of a company, we tend to look at them in two ways. We look at it on an accrual accounting basis, in which depreciation/amortization is included and the big capital expenditure is not. Then we also look at it as the pure cash flow burn rate, in which the big capital expenditure is included. When the cash leaves the bank account, the cash flow statement is going to be your friend. It adds those investing activities back into the burn rate and shows you what your true burn rate is.
VCs for Capital-Intensive Startups
If you’re running a capital-intensive startup, it’s usually harder to raise money but you will often have less competition. There is a subset of VCs that focus solely on those kinds of companies. So go find them! They will speak your language and they’ll be excited about what you’re doing!
If you have any other questions on capital expenditures, valuations, startup investing, startup accounting, or taxes, please contact us.
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FAQ
What is a capital expenditure?
A capital expenditure is a significant financial outlay that a company makes to acquire, upgrade, or maintain long-term assets. These assets, known as fixed assets or capital assets, are expected to provide benefits to the company for more than one accounting period, typically beyond a year. Capital expenditures are crucial for a company’s growth, maintenance of competitive edge, and long-term value creation.
Key characteristics of capital expenditures include:
- Long-term assets: CAPEX investments are made in assets with a useful life extending beyond the current period. This can include property, plant, and equipment (PP&E), as well as certain intangible assets.
- Capitalization: Unlike operating expenses, which are fully tax-deductible in the same year they’re incurred, capital expenditures are capitalized on the company’s balance sheet. This means they’re recorded as assets rather than expenses.
- Depreciation: The cost of capital assets is spread out over their useful life through depreciation. This depreciation expense appears on the income statement, affecting the company’s reported profits over time.
- Significant cost: Capital expenditures usually involve substantial funds spent on major projects or assets, distinguishing them from smaller, routine purchases.
- Future benefits: CAPEX investments are made with the expectation of generating future economic benefits, either through increased revenue, reduced costs, or improved operational efficiency.
Examples of capital expenditures include:
- Purchasing new manufacturing equipment
- Constructing or buying an office building
- Acquiring vehicles for business use
- Developing proprietary software
- Major renovations or improvements to existing facilities
It’s important to distinguish capital expenditures from operating expenses (OPEX). While CAPEX relates to long-term investments, operating expenses are short-term costs necessary for day-to-day business operations. These include items like office supplies, rent, utilities, and employee salaries. Unlike capital expenditures, operating expenses are fully deducted on the income statement in the period they’re incurred.
Understanding the difference between CAPEX and OPEX is crucial for accurate financial planning, tax purposes, and financial modeling. The treatment of these expenditures affects various financial statements:
- Balance Sheet: Capital expenditures increase the value of fixed assets.
- Income Statement: CAPEX impacts the income statement through depreciation expense over time, while operating expenses are immediately reflected.
- Cash Flow Statement: The full amount of a capital expenditure appears in the investing activities section, showing the immediate cash outflow.
For startups and growing businesses, managing capital expenditures is vital. While CAPEX investments can provide a competitive edge and drive growth, they also require careful consideration of funding sources, return on investment, and impact on cash flow. Companies must strike a balance between investing in long-term assets and maintaining sufficient working capital for day-to-day operations.
In financial analysis, metrics like the CAPEX-to-Sales ratio and maintenance CAPEX vs. growth CAPEX are used to assess a company’s capital expenditure strategy and efficiency. These insights help investors and management make informed decisions about a company’s long-term prospects and capital allocation.
How do you calculate CAPEX?
Understanding how to calculate CAPEX (capital expenditures) is crucial for financial planning and analysis. The CAPEX formula can be derived from a company’s financial statements, particularly the balance sheet and income statement. Here’s a comprehensive guide on how to calculate CAPEX:
Basic CAPEX Formula
The most straightforward CAPEX formula is:
CAPEX = Change in PP&E + Current Depreciation
Where:
- PP&E stands for Property, Plant, and Equipment
- Change in PP&E is the difference between the current and previous year’s PP&E value
If you are creating your financial statements by doing bookkeeping, this calculating CAPEX is relatively easy - assuming that you’ve kept good records and receipts. However, many times an investor is trying to understand capital expenditures from historical financial statements, so:
Steps to Calculate CAPEX
- Obtain the company’s balance sheet for the current and previous accounting period.
- Find the PP&E values for both years.
- Calculate the change in PP&E.
- Locate the current depreciation expense on the income statement.
- Add the change in PP&E to the current depreciation.
For a more comprehensive calculation:
6. Include changes in intangible assets.
7. Add current amortization expense.
Example Calculation
Let’s consider a hypothetical company:
- Current year PP&E: $1,000,000
- Previous year PP&E: $800,000
- Current depreciation expense: $50,000
CAPEX = ($1,000,000 - $800,000) + $50,000 = $250,000
This means the company invested $250,000 in capital expenditures during the current period.Tax Implications
Unlike operating expenses, which are fully tax-deductible in the same year, capital expenditures are typically depreciated over the asset’s useful life for tax purposes. This impacts a company’s taxable income and cash flows over multiple periods.
By understanding how to calculate and analyze CAPEX, investors and financial professionals can gain valuable insights into a company’s investment strategy, growth prospects, and long-term value creation potential.
What is PP&E (Property, Plant, and Equipment)?
PP&E, which stands for Property, Plant, and Equipment, refers to long-term tangible assets that a company uses in its business operations to generate revenue. These are physical assets that:
- Have a useful life of more than one year
- Are used in the production of goods or services
- Are not intended for resale in the normal course of business
Examples of PP&E include:
- Land and buildings (e.g., offices, factories, warehouses)
- Machinery and equipment
- Vehicles
- Furniture and fixtures
- Computer hardware
PP&E is a crucial component of a company’s balance sheet and is subject to depreciation over its useful life, except for land. Capital expenditures (CAPEX) often involve investments in PP&E, which can significantly impact a company’s cash flow and long-term value creation. Understanding PP&E is essential for assessing a company’s capital intensity, operational efficiency, and overall financial health.
