A growing business needs all sorts of assets, such as equipment, tools and buildings. Investments such as these are capital expenditures (usually called CapEx for short). To help you understand this key financial measurement, we’ll help you understand what capital expenditures are and how you can determine the right amount of spending for your small business’s goals.
What Are Capital Expenditures?
A capital expenditure is any amount of money spent to create a long-term benefit. When a business spends money to acquire long-term assets (assets they expect to use for at least a year), that money is the capital expenditure. Businesses spend capital expenditure funds on things like:
- Equipment and machinery
- Computers and software
Capital expenditure spending also includes the improvement of these assets. So, if you renovate your building or upgrade your equipment, that’s a capital expenditure, too.
Businesses also have operating expenditures — the money spent on the day-to-day costs of normal business operations. Operating expenditures are usually short-term costs, and they’re usually not pieces of physical property; they’re things like salaries, rent, utilities, taxes and other overhead costs. And even though your inventory includes physical goods, it still counts as an operating expense because you plan to sell the goods over the short term.
Buy, Lease or Rent?
For an expense to be considered a capital expenditure, you need to buy the asset. When you buy a long-term business asset, it counts as a capital expenditure because it adds value to your business. For example, if you bought the property your business is in, you’d give your business another asset and increases its net worth — hence it’s a capital expenditure.
If you lease or rent a business asset, that monthly payment is an operating expense. Because you don’t own the property, it doesn’t show up as an asset on your balance sheet and doesn’t increase your net worth. It’s just a cost you cover as part of running your business.
Buying, leasing or renting can be a reasonable strategy, depending on your goals — as long as you know the differences between leasing and financing equipment.
How Do Capital Expenditures Affect Your Finances?
Capital expenditure spending will show up on your balance sheet and your cash flow statement. You list your capital expenditures as assets on your balance sheet for the value of the property under the property, plant and equipment (PP&E) category. Your assets depreciate in value over time due to wear and tear, so you’ll need to adjust the value of your capital assets every year to account for the depreciation.
You track capital expenditure spending on your cash flow statement under investment expenses, showing that money has gone toward purchasing long-term assets. Your capital expenditures are listed separately from your operating expenses. Tracking where your money goes between categories is a key part of forecasting your cash flow and understanding your financial position.
When you buy an asset, you cannot deduct the entire purchase up front. Because capital expenditures are long-term assets, you need to follow depreciation rules and spread the deduction over the life of the asset, as required by the IRS.
There are ways, though, to get a larger tax deduction up front. You could use the 179 deduction for eligible property, for instance. As you’re figuring out which depreciation strategy to use, consider whether your business would benefit more from taking a greater deduction now or saving it for later to offset higher revenues after growing your business.
How to Calculate Capital Expenditures
If you want to know how to calculate capital expenditures for the year, it’s a pretty simple formula. First, look at the change in your PP&E total on your balance sheet. If you bought more capital assets, your PP&E total will have gone up; if you sold capital assets, it will have gone down. Then, add back any depreciation for the year. Your assets depreciate each year because of wear and tear, but that’s not part of your capital expenditure spending, so add that value back for this calculation.
So say that your PP&E total increased by $1 million over the past 12 months, and you also recorded $200,000 in depreciation over that period. Your total capital expenditure spending, therefore, was $1.2 million.
What Are the Pros and Cons of Capital Expenditure Spending?
- It increases your production capability and revenue potential. Your employees need the right tools to get the job done. Adding and upgrading your equipment, vehicles and machinery will make your staff more productive and boost your revenue potential.
- It adds to the value of your business. Capital expenditure investments show up as assets on your balance sheet, increasing your company’s net worth.
- It could reduce long-term costs. Owning your equipment, machinery and buildings outright means you don’t have to keep paying leases or rent. You’ll pay more up front, but you’ll usually save more over the long term.
- The upfront cost is higher. It costs more to buy assets up front. If you don’t have the cash flow to make this investment, you could take out an equipment financing loan.
- There’s more maintenance and upkeep. Capital expenditure spending doesn’t stop after you buy an asset. You need to keep up with repairs and maintenance to protect the value of your investment, and you also need to insure your property.
- It’s hard to project long-term value. Capital expenditures can last years, even decades. When you purchase an asset, you’re weighing the estimate of how much value you can wring out of it versus its upfront cost. There’s a lot of uncertainty in that calculation — situations can change, and results can differ wildly from expectations.
How Much Should You Spend on Capital Expenditures?
How much you should spend on capital expenditures depends on several factors. First, calculate your cash-flow-to-capital-expenditure ratio by dividing your total incoming business cash flow by your capital expenditures. If your ratio is greater than one — in other words, if you have more cash coming in than going out to capital expenditures — then your business is earning enough to cover the expected investments on sales alone. A ratio below one indicates aggressive capital expenditure spending — and might mean that you’ll need to borrow money or raise capital to cover it.
Exactly how much you should invest in capital expenditures hinges mostly on where your business is and how you plan to grow your business. Startup businesses and businesses with aggressive growth plans usually have higher cash-flow-to-capital-expenditure ratios because they’re spending more on capital expenditures. More established companies might have a ratio closer to one, especially if they aren’t trying to grow as quickly.
Your industry will also influence your capital expenditure spending. Capital-intensive businesses, like construction and farming businesses, typically spend more on capital expenditures than service-oriented businesses, which are less equipment-intensive.
How Much Capital Expenditure Spending Can You Afford?
Whether you can afford a new capital expenditure also depends on several factors. First, you need to figure out how you’ll finance the purchase. If your cash flow is high enough, you could pay for the asset using your own funds. Otherwise, you could consider taking out an equipment financing loan. Even if you have the money on hand, borrowing might still make sense, as it keeps your cash in reserve.
Before borrowing, consider whether you can take on the debt. Consider the monthly payments and your debt-to-equity ratio (your total outstanding debt divided by the value of your business). HubSpot estimates that a safe debt-to-equity ratio is between 1 and 1.5, though it could be higher for more capital-intensive industries.
Ultimately, you need to determine whether the extra productivity and revenue from capital expenditures will make up for the cost. If you clearly come out ahead, then feel confident about using capital expenditure spending to grow your business.