What is ‘Capital Expenditure (CAPEX)’
Capital expenditure, or CapEx, are funds used by a company to acquire, upgrade, and maintain physical assets such as property, industrial buildings, or equipment. CapEx is often used to undertake new projects or investments by the firm. This type of financial outlay is also made by companies to maintain or increase the scope of their operations.
Capital expenditures can include everything from repairing a roof to building, to purchasing a piece of equipment, or building a brand new factory.
BREAKING DOWN ‘Capital Expenditure (CAPEX)’
In terms of accounting, an expense is considered to be a capital expenditure when the asset is a newly purchased capital asset or an investment that improves the useful life of an existing capital asset. If an expense is a capital expenditure, it needs to be capitalized. This requires the company to spread the cost of the expenditure (the fixed cost) over the useful life of the asset. If, however, the expense is one that maintains the asset at its current condition, the cost is deducted fully in the year the expense is incurred.
CapEx can be found in the cash flow from investing activities in a company’s cash flow statement. Different companies highlight CapEx in a number of ways, and an analyst or investor may see it listed as capital spending, purchases of property, plant, and equipment (PPE), acquisition expense, etc. The amount of capital expenditures a company is likely to have depends on the industry it occupies. Some of the most capital intensive industries have the highest levels of capital expenditures including oil exploration and production, telecommunication, manufacturing, and utility industries. For example, Ford Motor Company, for the fiscal year ended 2016, had $7.46 billion in capital expenditures, compared to Medtronic which purchased PPE worth $1.25 billion for the same fiscal year.
Capital expenditure should not be confused with revenue expenditure or operating expenses (OPEX). Revenue expenses are shorter-term expenses required to meet the ongoing operational costs of running a business, and therefore they are essentially identical to operating expenses. Unlike capital expenditures, revenue expenses can be fully tax-deducted in the same year in which the expenses occur.
Using Capital Expenditures in Multiples for Relative Valuation
The cash flow to capital expenditure ratio, or CF/CapEX ratio, relates to a company’s ability to acquire long term assets using free cash flow. The cash flow to capital expenditures ratio will often fluctuate as businesses go through cycles of large and small capital expenditures. A ratio greater than 1 could mean that the company’s operations are generating the cash needed to fund its asset acquisitions. On the other hand, a low ratio may indicate that the company is having issues with cash inflows and, hence, its purchase of capital assets. A company with a ratio less than one may need to borrow money to fund its purchase of capital assets.
CF to CapEx is calculated as:
CF/CapEx = Cash Flow From Operations / Capital Expenditures
Using this formula, Ford Motor Company’s CF/CapEx = $14.51 billion/ $7.46 billion = 1.94. Medtronic’s CF/CapEx = $6.88 billion/$1.25 billion = 5.49. It is important to note that this is an industry specific ratio, and should only be compared to a ratio derived from another company that has similar CapEx requirements.
Capital expenditure can also be used in calculating free cash flow to equity (FCFE) to a firm with the following formula:
FCFE = Earnings Per Share – (CapEx – Depreciation)(1 – Debt Ratio) – (Change in Net Working Capital)(1 – Debt Ratio)
FCFE = Net Income – Net CapEx – Change in Net Working Capital + New Debt – Debt Repayment
The greater the capital expenditure for a firm, the lower the free cash flow to equity.