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What are capital expenditures and how to measure them

Business owners need new business software, equipment, facilities, and other assets, all of which come with potentially steep costs. When investing in these assets, it’s important to know how much you’re spending and whether each asset is worth the investment. When calculating these costs, you’ll want to measure capital expenditures or CapEx. If you can measure your capital expenditures, you’ll be able to set an appropriate budget for all assets and avoid overspending on what you need.

What are capital expenditures?

Capital expenditures are the specific costs of procuring, maintaining, and updating various tangible assets. Physical assets involved could comprise everything from buildings and other property to machinery, vehicles, and infrastructure. They are notably different from operational expenses (OpEx), which are the daily costs of running a business.

There are two central types of CapEx expenses. The first includes the costs of maintaining consistent operations, excluding repairs and basic maintenance, and the others have to do with facilitating long-term growth. If needed, businesses can typically sell these assets over time as they scale their operations. However, capital expenditures are often tailored for the company, making many of them far less reversible compared to other expenses.

Capital expenditures appear on cash flow statements in the form of a tax-deductible negative value. Over time, the various assets that count toward CapEx will begin to depreciate in value.

Why capital expenditures are important

With the help of the right CapEx investments, you’ll equip your company to grow in the long term. If you can purchase and maintain assets that yield a high return on investment, you’ll stand a better chance of flourishing in your industry.

You need to carefully consider CapEx for the following reasons:

Irreversibility

It’s often challenging to reverse capital expenditures because of the potential financial repercussions. This is largely because many assets you choose will be uniquely beneficial for your business, making them less applicable to others if you wish to put them back on the market. You should choose assets that you’re most likely to commit to using on a long-term basis.

Depreciating value

Although the assets you purchase at first might come at a high initial cost and have high value before use, their value will start to depreciate. As soon as you begin implementing the different CapEx assets for your business, your asset accounts will see a gradual decrease.

Future considerations

When selecting assets for your business, you also need to consider how they will affect your company’s future. Think about the capabilities of your assets—are they capable of keeping up with you as your company grows? Also, set specific and achievable goals to help you establish your CapEx budget.

How to measure capital expenditures

Calculating your capital expenditures can help you avoid going over your allotted budget when spending money on all types of assets. You can measure capital expenditures using your balance sheet, cash flow statement, or income statement. Additionally, you can follow these steps when calculating CapEx:

Get ahold of your business’s financial statements

The first step is to obtain your income statement or balance sheet that covers the past two years. You’ll be able to use these forms to help with your calculation.

On these documents, you’ll want to look for a few key items that will enable you to measure CapEx. The first of these is the current and previous period’s property, plant, and equipment (PP&E), which are the fixed assets on your balance sheet. They can include any machinery, equipment, vehicles, and facilities that your company possesses.

Then, on the income statement, look for the amortization and depreciation.

Use the formula for calculating capital expenditures

The next step is to apply the formula for calculating the CapEx. The formula will look like this:

Current Period’s PP&E - Previous Period’s PP&E + Current Period’s Depreciation = CapEx

Based on this formula, you’ll want to take the assets from the current period and subtract the fixed assets from the previous year. Don’t count any intangible assets or assets that you acquired via acquisitions during the reporting period. This will give you your “Current Period’s PP&E.”

Once you have this number, you can subtract the accumulated depreciation of the previous period from that of the current period. The result will be the “Current Period’s Depreciation.” Following the subtractions, you can add the “Current Period’s Depreciation” to give you your capital expenditures for the current period.

How to stay within your budget when investing in CapEx

If you’re wondering how to set the right budget for your capital expenditures, there are some ways to do so and get the most from these expenses. These include:

Ensure the CapEx is worth it

Before investing, consider the logistics of the investment and whether it will benefit you in the long run. Think about what kind of ROI you can expect on the investment and when you can expect to see it. Also, consider the extent of the project and what it will entail, along with the CapEx’s value compared to other types of expenses.

Consider financing

In many cases, business owners may be able to spend available capital on CapEx investments, but you may benefit from a financing option if this is more ideal. When taking financing into consideration, make sure you understand what the different options will give you and determine whether you’ll be able to pay off any debt before committing to any loan.

Prepare for any inconveniences

Keep in mind that something could go wrong with any type of CapEx project. Preparing for potential issues can help you avoid or navigate them. Consider the various factors involved in the project, including the types of resources you’ll need. Additionally, consider how the project could impact your company’s operations and what you might need to do to avert potential inefficiencies.

Calculate the CapEx ratio

You can more effectively budget for CapEx by using the CapEx ratio, which involves the following formula:

Operating Cash Flow / Capital Expenditures = CapEx Ratio

You may also need to subtract any dividends from “Operating Cash Flow” if you need to pay equity holders.

When you calculate the CapEx ratio, the total value should be higher than one. This would show that you have enough money coming in to spend on CapEx as your business grows. If the ratio falls below one, you may require additional funding from other sources.

Measure and carefully invest in capital expenditures

Taking the right approach to CapEx will help you make the most of these necessary expenses. With the best investments, your business will have the chance to grow and experience long-term success.

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