What is Capex?

Imagine you’ve just purchased a new vehicle…

The vehicle itself is a capital expenditure because it’s a physical asset that you’ll enjoy in the future. But the gasoline you put in the vehicle every month is an operational expenditure or an Opex. This is because you don’t see the benefit of that gasoline month after month.

Capex is the money spent on fixed assets, which are expected to benefit the company a lot longer than just the current year.

Here are some common Capex examples you might see:

• Land
• Buildings (both buying and making significant upgrades)
• Office furniture
• Computers
• Office equipment
• Machinery (both buying and making substantial upgrades)
• Vehicles
• Software: Software is typically considered Capex, but more and more often is being switched to Opex. Businesses traditionally would have invested in software and IT upfront. Software continues to be considered a Capex only when a company purchases it upfront as an asset that will benefit the company for at least one year.
• Patents, copyrights, trademarks, intellectual property, etc.

Capex consists of the investment into fixed assets that companies hope will generate long-term value. But not every asset has a simple upfront cost — some costs are ongoing. That’s where Operating Expenses (“Opex”) come in. These are the day-to-day expenses incurred by a business to keep everything running smoothly. Capital expenditures are an upfront investment that a company can benefit from for years. Operational expenditures are those that you benefit from at the time but add no long-term value. These are often recurring expenses.

Capital expenditures depreciate over a period of time. But operational expenditures are fully deductible in the same year. Most of the costs incurred by a company are operational expenditures, so think of them as the cost of doing business.

We talked earlier about the example of the new vehicle. The car itself is a fixed investment or capital expenditure, but the gasoline purchased for it would be an operational expense. That car would also come with other operational costs, such as insurance.

Let’s talk about some other common Opex examples.

• Rent: Many businesses choose to rent their space instead of buying a building. This would be an operational expenditure, as it brings no fixed asset to the company.
• Building utilities
• Property taxes: Buying a building counts as a capital expenditure. But the building still requires operational expenditures. For example, property taxes are operational expenditures.
• Salaries and benefits
• Business travel
• Administrative expenses
• Insurance and legal expenses
• Sales and marketing expenses
• Software: We mentioned earlier that software was traditionally considered a capital expenditure. It is now more often considered an operational expenditure, which is why it can be categorized as either a Capex or Opex.
• Other expenses: This includes additional costs of doing business that show up on the income statement.

In general, the lower a company’s operating expenses, the better. This number is essential because you can calculate the operating profit using Opex. Using the operating profit, you can calculate the net profit. And the net profit is a number that is closely watched because it gives you an idea of how a company is doing for its shareholders

Here’s a quick summary of the difference between Capex and Opex:

There are advantages and disadvantages to both Capex and Opex.

A company can deduct the entire amount paid for an Opex in that calendar year, which means there are immediate tax benefits. Capital expenditures work a bit differently. The company can only deduct a certain amount per year for the expense, and then continue to do so over many years.

Let’s look at a real-world example. Some businesses choose to buy real estate, which would be a capital expenditure. Others choose to rent a property, which would be considered a recurring operational expenditure. This might be an intentional choice — the company can deduct the entire rent amount every year, while the alternative is depreciating the cost of a building over many years.

If the annual rent amount is higher than the depreciation expense would be, then Opex would be expected to have a better immediate tax benefit. And if that is your only consideration when choosing between the two, then Opex might be preferable.

But there are certainly benefits to capital expenditures as well. Capex is an asset on a balance sheet – And increasing the company’s assets could be attractive to investors. Capex does not allow a business to receive the entire tax benefit in one year as Opex typically does. But there is still some tax benefits to the company every year as the item depreciates.

Capex is always located under “Investing Activities” on the cash flow statement, which is used to show the amount of cash generated and used in a given period of time. But if you don’t have access to the cash flow statement, then you can calculate Capex. You can do this using the information on the income statement and balance sheet.

Here’s the formula for calculating Capex:

Capex = Current PP&E - Old PP&E + Current Depreciation Expense

Now let’s take a step back. There might be some words and abbreviations in that formula that you aren’t familiar with.

PP&E stands for Property, Plant, and Equipment. This represents the fixed, tangible assets owned by a company. They are physical assets that a company cannot easily liquidate. The Capex formula takes into account the PP&E for the current period indicated on the balance sheet. It also takes into account the PP&E for the prior period. These two numbers together show the net change in PP&E.

When calculating Capex, you’ll also need to take into account depreciation of Property, Plant, and Equipment from the current period. You can find the current period depreciation and amortization on the balance sheet or income statement.

Now that you understand what each of the terms in the formula represents, you can use a company’s financial statements to determine its capital expenditures.

Capex is an investment that will provide future benefit to the company. Because of this, companies account for it differently than Opex.

Companies deduct operational expenses in the same year they make them. But they capitalize capital expenditures and spread it out over several years. The number of years over which a company capitalizes an item depends on the expected life of the asset. Every year the asset depreciates, and the company deducts the depreciation amount on their taxes for the year.

Let’s say, for example, that a company purchases a new piece of equipment for $25,000. Imagine the expected life of the item is five years. If there is no salvage value for the vehicle and if the company uses straight-line depreciation, then in each of the next five years, the company would record $5,000 of depreciation. They record this depreciation as an expense.

Companies record capital expenditures in a couple of different places. First of all, the company records them as assets on the balance sheet, as we discussed earlier. Additionally, they record the amount of depreciation as an expense.

We now know what Capex is, how it differs from Opex, and how companies calculate and account for it. But what does this truly mean for investors? Why is Capex important? Is it necessary to understand a business?

Capex can often be an indicator of good financial health for a company. Fixed long-term assets are difficult to sell off (aka liquidate into cash). So capital expenses are usually not a decision that a company makes lightly. If the business feels confident in its financial future, then investors often can too.

Likewise, a company liquidating assets might be a sign of financial trouble. For example, Financial Industry Regulatory Authority (FINRA) said in an Investor Alert report dated November 2015 that during the 2008-2009 recession, “one survey found that 60% of companies slashed Capex. But as soon as the economy recovered, so did Capex.”

These aren’t hard and fast rules, though. Research published in the same FINRA post notes that “companies that spent more on Capex last year saw their shares perform worse than companies that spent more on share buybacks and dividends.”

Capex can help serve as an indicator to investors of the financial well-being of a company, but it’s only one signal of many that can help investors or analysts learn more about a business.

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