A capital expense, also known as a capital expenditure or CapEx, refers to a significant, long-term investment made by a company to acquire, upgrade, or extend the life of tangible assets. These assets are typically used in the production of goods or services and have a useful life that extends beyond the current accounting period. Examples of capital expenses include the purchase of the property, buildings, equipment, vehicles, and other long-term investments that contribute to the company’s ability to generate revenue over an extended period.
- A capital expense refers to significant expenditures made by a business for acquiring, improving, or maintaining long-term assets, which are expected to provide benefits over an extended period.
- Capital expenses are distinct from operating expenses (OpEx). While operating expenses are incurred for day-to-day operations and are typically shorter-term costs associated with running the business, capital expenses involve strategic investments in assets like property, machinery, or technology.
- Capital expenses are recorded as assets on the balance sheet, contributing to the company’s overall assets. The cost is then spread over the asset’s useful life via depreciation expense, reflecting a portion of the asset’s cost considered an expense in each accounting period.
- While capital expenses may not immediately impact profitability, they play a crucial role in shaping a company’s financial position. They increase the value of assets and contribute to a company’s net worth, influencing financial ratios.
Types of Capital Expenses
There are three types of capital expenses:
- Tangible assets: These include physical assets like land, buildings, machinery, vehicles, and equipment.
- Intangible assets: These are nonphysical assets with value, such as patents, copyrights, trademarks, and goodwill.
- Software: In some cases, the cost of developing or acquiring software that has a long useful life may be considered a capital expense.
Considerations for Capital Expenses
Understanding and managing capital expenses are crucial aspects of financial management for businesses, as they impact the company’s financial statements, profitability, and overall competitiveness in the market. Following are some considerations for capital expenses:
Formula for Determining Capital Expenses for a Period
The formula for determining your company’s CapEx for a period calculates how much a company spends on acquiring or upgrading long-term assets, such as property, plant, and equipment (PP&E).
Based on your balance sheet, the formula for figuring the amount of capital expenses your company incurred during the year is:
Capital Expenses = [PP&E (current period) – PP&E (prior period)] + Depreciation (current period)
- PP&E: Companies classify any physical asset that helps them generate revenue as PP&E. In the below example, the PP&E amount must be net of accumulated depreciation.
- Depreciation: You’ll find this amount on your income statement, this allocates the cost of an asset over its useful life
The above calculation is for PP&E CapEx. CapEx for intangibles can be calculated similarly using net intangible assets and amortization expense.
It’s also important to note that not all costs associated with an asset are considered capital expenses. Some costs may be treated as operating expenses if they are incurred for the day-to-day operations and maintenance of the asset rather than for its acquisition or improvement. These operating expenses related to capital assets won’t show up in the capital expense number since they aren’t included in PP&E.
Example of a Capital Expense
To put the above formula into practical use, suppose your small business made several large capital expenditures during the year and you’d like to know the total amount. You can calculate your total capital expenses easily by referencing your financial statements.
To calculate the capital expenses in 2023, you gathered the following information from your financial statements:
- Depreciation in 2023: $20,000
- Net PP&E on Dec. 13, 2023: $150,000
- Net PP&E on Dec. 13, 2022: $100,000
In this example:
Capital expenses = ($150,000 – $100,000) + $20,000
Capital expenses = $50,000 + $20,000
Capital expenses = $70,000
Pros & Cons of Capital Expenditures
How Capital Expenses Affect A Business
Capital expenses have a significant impact on businesses in various ways, influencing their financial health, operational efficiency, competitiveness, and strategic direction. Here are some ways in which capital expenses affect a business:
- Asset value and long-term growth: CapEx involves investments in long-term assets, such as property, equipment, or technology, contributing to the overall value and growth potential of the business.
- Operational efficiency: Upgrading or acquiring new equipment through CapEx can enhance operational efficiency, leading to increased productivity and cost savings over time.
- Competitive advantage: Capital investments in technology, infrastructure, or other strategic areas can provide a competitive edge by allowing the business to offer better products or services to competitors.
- Depreciation and accounting impact: The depreciation of capital assets can impact the company’s financial statements, affecting profitability and net income. The accounting treatment of CapEx can influence how investors and analysts perceive the company.
- Administrative burden: Managing and maintaining capital assets requires ongoing resources, including personnel training, and maintenance costs. This can place an administrative burden on the business.
Differences Between Capital vs Operating Expenses
The categorization of expenses as CapEx vs OpEx is essential for financial reporting and accounting purposes, as it impacts how these costs are treated on the company’s income statement and balance sheet. Additionally, accounting standards and tax regulations may influence the treatment of certain expenditures.
There is often a gray area in determining whether an expenditure is a capital expense or an operating expense. You can learn more about making this important determination in our article When To Capitalize vs Expense Payments Made.
Frequently Asked Questions (FAQs)
Examples of capital expenses include the purchase of real estate, machinery, vehicles, and expenditures on significant improvements or upgrades to existing assets. Costs associated with long-term investments in software development or research and development may also be considered capital expenses.
Capital expenses are related to long-term investments in assets like property, equipment, or technology. They are capitalized on the balance sheet and depreciated over time. Operating expenses, on the other hand, are day-to-day costs incurred in the normal course of business operations and are expensed on the income statement.
Generally, no, as there is no strict minimum threshold for an expense to be considered a capital expense. However, businesses may establish their own capitalization policies based on materiality, considering the significance of the expenditure in relation to the overall financial position of the company.
Capital expenses are capitalized on the balance sheet, meaning they are recorded as assets. The cost is then spread over the asset’s useful life through methods like depreciation or amortization. The annual depreciation expense is recorded on the income statement.
No, capital expenses generally cannot be immediately deducted but instead must be deducted over time as depreciation expense. However, there are two major exceptions to this that allow an immediate deduction via Bonus Depreciation and Section 179.
A clear understanding of capital expenses is essential for businesses seeking to make strategic investments in their long-term assets. From its treatment in financial statements to its impact on a company’s financial position, capital expenses play a vital role in shaping the financial narrative of an organization. Businesses are encouraged to work closely with accounting professionals to navigate the complexities of capital expenses and ensure sound financial management.