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Budgeting for capital expenditures (CapEx) is essential for a business to grow and operate. Companies should create a sound CapEx plan to avoid any expense overruns. Because these expenses represent substantial investments of cash designed to show a return on the capital investment for years, they need to be carefully planned. Taking into consideration all costs, market expectations, and business growth is crucial when drafting a capex plan.
Key Takeaways
- Capital expenditures are essential for a business to grow and operate and are much higher than operational expenses.
- CapEx budgeting varies by company and requires separating it from operational expenses.
- Departments should add their input and management should determine whether the investment in CapEx is worth the cost.
What Are Capital Expenditures?
A capital expense is the cost of a useful asset that helps create profits for a period longer than the current tax year. This distinguishes it from an operational expenditure, which is an expense that is related to an asset purchased and consumed within the same tax year. For example, printer paper is an operational expense, while the printer is a capital expense.
Capital expenditures are much higher than operational expenses, covering the purchase of buildings, equipment, and company vehicles. Capital expenditures may also include items like money spent to purchase other companies or for research and development (R&D). Operational expenses are just what their name signifies—the expenses required for the company to operate on a weekly or monthly basis.
Capital expenditures carry benefits and risks. Investing in CapEx can improve a firm’s efficiency and allow it to gain a competitive edge. But it may fail to perform as expected, resulting in losses that could have been allocated elsewhere.
Fast Fact
You can find a company’s CapEx on its cash flow statement and balance sheet.
Capital Expenditure Planning
Preparing a capital expenditure budget varies from one company to another depending on certain factors, such as the nature of the company’s business and the size of the company.
Separating Expenditure Budgets
Most companies budget their capital expenditures separately from others. Having a separate budget from operational expenses makes it simpler for companies to calculate the respective tax issues.
The Internal Revenue Code (IRC) allows an operational (or ordinary) expense to be deducted within the year you incurred it. Deductions for capital expenditures, on the other hand, are spread over years as depreciation or amortization.
Department Input
Much of the need for CapEx comes from the assessment of department heads, who run the day-to-day operations of a certain group. They are well aware of any issues within their group that would need updating or replacement.
This bottom-up approach assessment helps determine whether any of these expenditures benefit long-term growth, what is economically feasible, and the return on investment (ROI). In the end, CapEx is inevitably determined by upper management and owners.
Implementing a Budget Limit
Determining the maximum amount spent on capital is a crucial early step in CapEx planning. Making a thorough assessment of CapEx needs, whether for maintenance, new acquisitions, or growth from different departments determines the range in how much to budget for CapEx. Once a company decides its spend limit, it can shape a plan around that.
Measuring Capital Expenditure Returns
A budget is devised based on need and business growth and CapEx is completed after different departments give their input. The company must then determine the returns on its capital expenditures.
This lets the business determine if its valuations were correct, whether the investments are paying off, and what went right (and wrong) so these decisions are continued or improved during the next cycle.
Many financial tools are available to assess the returns of capital expenditures, particularly the timeframe in which the investments will start to pay back. ROI ratios, hurdle rates, and payback periods are areas to analyze when determining the benefit of a capital expenditure.
Management’s Role in Capital Expenditures
Capital budgeting involves very large expenditures, and management must evaluate whether the investment in assets is worth the cost. Capital expenses almost always impact operational expenses as purchased items need to be maintained and the big picture needs to be considered.
Management must decide whether capital expenditures come directly from company funds or if they must be financed. Financing increases a company’s debt level, which also needs to be considered. Leasing is an option as well, one that becomes appealing if a company buys assets like computers or other technology equipment—items that can quickly become obsolete.
In deciding on capital expenditure for a certain item, a company’s management makes a statement about its view of the company’s current financial condition and its prospects for future growth.
Capital budgeting decisions also indicate what direction the company plans to move in the future. Capital expenditure budgets are commonly constructed to cover periods of five to 10 years and can serve as major indicators regarding a company’s five-year plan or long-term goals.
How Do You Determine Depreciation?
Depreciation refers to the reduction in value of an asset over time. Businesses use depreciation as an accounting method to spread out the cost of the asset over its useful life. There are different methods, including the straight-line method, which spreads out the cost evenly over the asset’s useful life, and the double-declining balance, which shows higher depreciation in the earlier years.
Why Is CapEx Important to a Business?
Capital expenditures are an integral part of a company’s business structure. They represent long-term investment in corporate growth (such as the purchase of new facilities and/or equipment), the expansion into new markets and product lines, improving operations, and, staying ahead of the competition.
What Are Some Examples of CapEx?
Capital expenditures are any assets that add long-term value to a company. They include things like buildings, land, equipment, furniture, computers, and vehicles. Intangible assets, such as goodwill, patents, trademarks, and software may also be considered capital expenditures.
The Bottom Line
Capital expenditures are a large cost for a company but usually necessary. They come with many benefits and many risks, which is why it is imperative to create a sound and thorough capital expenditure budgeting plan that takes into consideration all variables. If a company can do this correctly and execute capex investments appropriately, it will lead to positive growth and success for the firm.
