Capital expenditures (called CapEx for short) are business investments in assets that last more than one year including improvements and upgrades of existing assets. These can be physical assets like equipment or intellectual property.
Here are some examples of what can be considered capital expenditures:
- Equipment and machinery
- Buildings
- Land
- Vehicles
- Furniture
- Computers and servers
- R&D for patents and other intellectual property
- New HVAC system
- Laying fiber optic cable
CapEx is different from operating expenses because the capital expenditure purchases an asset for the business, whereas operating expenses are simply costs to run the business this year. Purchasing manufacturing equipment is a capital expenditure, but maintenance to keep the machines running is an operating expense. That’s why businesses depreciate CapEx over multiple years but immediately expense operating costs.
Capital expenditures also mean that a business purchases the asset instead of renting it. Here’s what this looks like. You can use an equipment financing loan to buy a new semi-truck and that would be CapEx, but leasing it (where you have the option to purchase it or give it back to the leasing company after a period) would be an operating expense.
To see the difference between capital expenditures and operating expenses for your business, start by gathering your financial statements including your balance sheet, income statement, and statement of cash flows.
Finding Capital Expenditures on Your Financial Statements
Capital expenditures show up in 3 places on your financial statements:
- On your balance sheet under Property, Plant, & Equipment (PP&E) because CapEx purchases are business assets
- Under the Investing Activities section of your cash flow statement to show the outflow of cash from the business to buy the asset
- As depreciation expense on each year’s income statement
Depreciation represents the cost to your business for the asset wearing down and losing value over time. Even though it doesn’t take any cash, you deduct depreciation each year as an expense. This reduces the value of your asset on the balance sheet by the amount of depreciation.
If you use a loan to purchase CapEx, the interest expense from the loan gets deducted from your income statement in addition to the depreciation expense.
Quick CapEx Calculation
Instead of adding up individual receipts for assets you bought this year, use this formula to quickly calculate CapEx:
- PP&E at end of this year (from your balance sheet) – PP&E at end of last year (from last year’s balance sheet) + Depreciation Expense (from this year’s income statement)
If you ended last year with $1 million in PP&E, ended this year with $1,200,000 and had depreciation expense of $100,000, then your CapEx this year was $300,000 = $1.2 million – $1 million + $100,000.
Depending on your business and when you purchased different assets, that might be a high number or a low number, so here’s how to budget and compare CapEx for your business.
How Much to Spend on Capital Expenditures
How much you should spend on capital expenditures depends on the assets you already have, whether they can produce enough to meet your business forecast, and what your financial situation looks like.
Start by setting aside two months of fixed costs in cash reserves to make sure you have a safety net for rent, wages, and other must-pay expenses. Next, follow this 3-step process to figure out what you can spend on capital expenditures:
- Create two lists:
- Replacement capital expenditures
- Growth capital expenditures
2. Stress test debt levels.
3. Compare available debt service levels to capital expenditure needs.
Two Capital Expenditures Lists
Create two lists for CapEx with one list for expenditures to replace aging assets and another for new assets to grow your business.
- Replacement CapEx is a matter of when versus if because your assets wear down over time, so you need to upgrade or replace them to keep the same level of production/sales. For example: Older machines won’t keep up with the same level of production forever, aging vehicles break down, and even intellectual property loses power over time.
- Growth CapEx is the list of assets to increase your productivity and revenue.
Because replacing old machines with new ones can grow your business with increased production or better productivity, you’ll be able to factor growth rates into the next step where you stress test the debt levels for your current financial position. This tells you how much (if any) extra debt your business can afford without risking bankruptcy in case growth doesn’t meet expectations.
Stress Test Debt Levels
This 4-step process stress tests your future debt levels to tell you how much (if any) additional debt your business can afford for capital expenditures. The goal for the test is to keep your debt service coverage ratio above 1.25, which is the minimum level most lenders require for new loans:
- Add up your total debt service payments including monthly principal and interest payments.
- From your most recent annual income statement, add together these numbers:
- Net income
- Interest expense
- Tax expense
- Depreciation & amortization
- Divide the result from step 2 by 12 to get a monthly number. Then divide by 1.25.
- Subtract the number in Step 3 from the result in step 2 and that is your available monthly cash flow to service new debt before you drop below what most lenders require.
Here’s an example calculation using the hypothetical income statement in the table below:
- Step 1: Assume the monthly principal and interest payments are $6,600 for this example.
- Step 2: From the table below, $439,000 + $188,000 + $23,000 + $50,000 = $700,000.
- Step 3: $700,000 / 12 = $58,333 / 1.25 = $46,666.
- Step 4: $46,666 – $6,600 = $40,066.
| Income Statement for Example | |
| Revenue | $2,000,000 |
| Cost of Goods Sold | $1,000,000 |
| Operating Expenses | $300,000 |
| Depreciation | $50,000 |
| Interest Expense | $23,000 |
| Taxes | $188,000 |
| Net Income | $439,000 |
In this situation, you can cover another $40,000 in debt payments and keep a debt service coverage ratio above 1.25 to satisfy lenders. If you’re thinking about growth CapEx, start with a safer ratio of 1.5 in case sales don’t come in as fast as you thought. In this example, replace the “1.25” with “1.5” and the formula indicates that you can manage another $32,289 in monthly debt payments on top of your existing $6,600.
Compare Available Cash Flow to Needs
The final step is comparing the available cash flow from step 2 to the potential monthly payments for items on your lists in step 1.
If you’re thinking about a new $3 million headquarters facility purchased with a 10-year mortgage at 8%, monthly payments would come out to about $36,000. That’s more than the “safe” $32,289 and almost all of the $40,000, so you wouldn’t be able to replace other aging assets much less fund growth capital expenditures with a small business loan.
Alternatively, if new machines costing $1 million allow you to capture excess demand, growing revenue by 5%, a 10-year 10% equipment financing loan would take up $13,215 in monthly debt service. And that would leave plenty of room to cover other needs from the lists you created in step 1. On top of this, the 5% revenue growth adds almost another $50,000 to operating cash flow, so you’d have a sizable buffer in your debt service ratio.
Pro-Tip: Leverage equity financing, which is different from debt financing, to fund replacement and growth capital expenditures, too. Equity financing helps spread the risk for growth capital expenditures, while debt financing can fund replacement assets.
Ultimately there’s no “right” amount of CapEx to spend. It all comes down to which assets you need to replace to keep the business running and then what you’d like to buy for future growth.
Capital expenditures are business investments for long-lived assets lasting over one year. They’re necessary to keep a business running by replacing old and out-of-date assets, and you’ll also need them for growth. How much you spend each year depends on your financial situation, how much cash flow you have to service debt or if you can get outside equity investment, and how much the assets cost.
Whether you’re a software company that only needs CapEx for computers and servers or a long-haul trucking company that needs capital for trucks, trailers, and warehouses, National Funding offers all types of business loans for numerous industries. Apply online today to see what we can do for your business.
National Funding does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only. You should consult your own tax, legal and accounting advisors.
