At the market level, where a big proportion of the equity is services and technology stocks, the accounting for expenses in these sectors (treated as operating) creates questions about whether the Capex and the Opex are even comparable over time.
Operating expenses, or Opex, are recorded on the income statement, and not on the balance sheet.
Capital expenses, or capital expenditure, are booked as an asset and liability. A lot of these service-oriented companies are essentially “taking ownership” of an asset without the burden of reporting that on the balance sheet.
This gives an incomplete picture of where the company stands making it difficult to evaluate the true earnings.
What exactly is Capital Expenditure (CapEx)?
How does a company/organization set a number on CapEx and is its free cash flow, but must be used for obtaining assets, products, etc?
It is the same as when a company buys a non-consumable good they intend to keep indefinitely. Let’s say you buy a printer – that is a capital expense, but paper for the printer is not, it’s an expenditure of capital/investment.
The printer and the paper are accounted for differently because they represent one-time purchases – as opposed to recurrent expenses.
You are usually allowed to deduct depreciation of goods purchase through capital expenditures.
Capital expenditure is the money spent by a business, in pursuit of acquiring (or maintaining) fixed assets like land, buildings, or equipment.
CapEx is also any expenses in excess of $5k that bring value to the finished products and it can be amortized and depreciated over time. Because they bring that value they can increase the tax burden due to appreciation in the value of the original asset.
In some situations, field operation managers can create a “wish list” for their area of responsibility. It is then reviewed by the owner for approval. Then, it is assigned to the respective department for processing and completion.
What’s the goal here?
The goal with capital expenditure is to maximize the expansion (profitability) of the business, without overextending so much that it hurts the bottom line.
You have to spend money to make money, but if you spend too much on the new machinery, you’ll run out of money to keep it going before it turns a profit.
It’s a delicate balance, and in the end – that’s why CFO’s are paid a lot of money to keep the business going.
What exactly is Operational Expenditure (OpEx)?
The opposite of Capital Expenditure (CapEx) in Operational Expenditure (OpEx).
While CapEx leaves you with something you “keep” and can eventually “resell” (equipment, a building you own), OpEx is something you use up either immediately or soon, and something you use on a somewhat regular basis (supplies like staples or paper, or – rent payments).
Let’s assume you know pretty accurately that every month you pay certain operational expenses:
- $X for rent,
- $Y for payroll,
- $Z for supplies,
- $A for electricity,
- $B for advertising, etc.
An example that can explain the factors in deciding about investing extra cash (or funds from an investor or bank loan) goes like this:
- When you buy a building (CapEx), is it worth it given the decrease in rent (OpEx)?
- When you buy a new robot (CapEx), is it worth it given the decrease in payroll (OpEx)?
Obviously, the trade-offs in real estate happen over time, and you’re taking a risk in the future. The robot will also affect your electrical bill, and owning a building adds other operational expenses, too.
But that’s a basic way to look at the decision-making process.
A Word On Free Cash Flow
A free cash flow is a number determined to show how much (more or less) money a business has available for use at the end of a financial period.
It is calculated by taking the operating cash flow and taking away your CapEx.
Operating cash flow basically represents the net profit of your business, but you can only count the money you actually received/paid – whereas revenue and expenses (and therefore profit) are recorded at the time they were earned and not the time they were received/paid.
Three Types Of Capital Expenses
I’ll keep it simple.
- Cost of Goods sold – Items you purchase, often assembled for a final product (steel, glass, plastic, batteries, and tires are components of a car). There might be a significant expense here – but it is not CapEx.
- Operating expenses – Things you spend money on to run your business; rent, salaries, etc.
- CapEx – Large, tangible items. Anything that extends the life of an asset (new roof) to machinery. What is large? – You can set the amount.
Taking Control of CapEx and OpEx
If you want to run a successful business, there are financial terms you should always familiarize yourself with. For instance, my blog on the difference between CapEx and OpEx has been enough to make you rethink some decisions and contact a professional before you dive into strategic investments (and CapEx project management).
It is obvious that operational expenses and capital expenses together account for a fairly large percentage of the company’s annual budget and finances.
When you’re trying to cut costs, it is a better catch balance between CapEx and OpEx, than cutting either or both budgets.
Managing huge CapEx projects and juggling both CapEx and OpEx it is vital to have expense transparency – and you need to gain full control.