Obtaining a small business loan presents the perfect opportunity to make new capital expenditures for your company. However, before you begin making these important CAPEX investments for the business, it’s important to understand the difference between a capital and an operating expense, as well as which items you can depreciate over time. These terms have unique definitions, and understanding what they consist of and how they impact your company’s budget can assist in long-term financial planning that will ultimately help you grow your business.
A solid understanding of the types of expenses used by businesses of sizes will not only provide you with a firmer financial foundation, it will help with budgeting techniques as well as give you a better grasp of the jargon used. This can go a long way when it comes to conversing with other business owners at networking events or when you decide to apply for a small business loan.
Much like the term suggests, operating expenses are the day-to-day costs a company incurs during the regular course of doing business, and because of this are also sometimes referred to as business expenses.
These include any rent for office, retail or warehouse space, as does business travel, utilities, basic supplies, insurance fees, employee wages and even customer entertainment costs. Essentially, any tangible item that might need to replaced on annual basis. Even inventory can be an operating expense for companies that rely on it. However, service-based businesses might not be as reliant upon inventory.
Since properly budgeting for these items is vital for managing cash flow, it can be wise to stay on the conservative side for estimates. When projecting eventual receipts for these costs, err on the high side for expenses and underestimate for incoming revenue. Regularly review and identify costs for past months to isolate spending patterns and classify them by category and date. This helps you make more accurate forecasts for these expenses, which ultimately leaves more flexibility for dealing with unexpected costs and unforeseen issues.
Whereas operating expenses are ones you absolutely need to conduct regular business, capital expenditures are fixed business purchases you make as part of the investment in the company that could potentially assist in growth over time. These expenses are assets, and the IRS lists out three types of cost to capitalize: startup costs, assets and improvements.
Capital expenditures include real property, equipment, auto and light trucks, computers and any other tangible items that will last more than a single year. The cost of these items cannot be deducted in the year they were purchased, and instead, you amortize these expenses over the useful life of the asset. This means you gradually write off the initial cost over time, as opposed to immediately after purchase.
This term is used synonymously with amortization, and they both mean to write off the cost of asset through annually claimed tax deductions. To recover the full cost of certain types of property over time, it’s imperative that you have a solid understanding of how depreciation works, as well as what items you can depreciate and how long this process lasts. As noted by the IRS, this lets you claim deductions for wear and tear, deterioration or obsolescence of the property over time.
While there are many different items that can be depreciated (as noted in the capital expenditures section), generally, these items must:
- be a property the business owns
- used to produce income or otherwise generate revenue
- have a determinable useful life
- be expected to last more than one year.