Capital Expenditure (Capex) refers to a company’s long-term investments in fixed assets (PP&E) to facilitate growth in the foreseeable future.
Like the change in net working capital (NWC), Capex – short for “Capital Expenditure” or “Capital Expense” – is classified as a reinvestment activity.
For the vast majority of companies, Capex is one of the most significant outflows of cash that can have a major impact on free cash flow (FCF).
In This ArticleTable of Contents
Capital expenditure, often abbreviated as “Capex,” describes the funds spent by a company to acquire, upgrade, and maintain physical fixed assets, such as property, buildings, and equipment.
For example, the act of repairing a roof, building a new factory, or purchasing a piece of equipment would each be categorized as a capital expenditure.
With regard to the proper accounting methodology, capital expenditures (Capex) must be depreciated – i.e. “spread out” – across the useful life of the fixed asset (PP&E) rather than being recognized in the year of actual incurrence.
The rationale for gradually reducing the fixed asset (PP&E) balance via depreciation – a non-cash expense recognized on the income statement – is intended to align the cost with the revenue generated, i.e. the “matching principle.”
The difference between capital expenditure (Capex) and operating expenses (Opex) is as follows.
Capital expenditures (Capex) include the purchase of new fixed assets and repairing, or upgrading existing long-term assets, such as the following examples:
The capital expenditure (Capex) of a company in a given period can be determined by tracking the changes in the company’s fixed assets (or PP&E) balances recorded on the balance sheet, along with the current period’s depreciation expense from the income statement.
However, a separate line item for the depreciation expense is seldom found on the income statement.
Therefore, the depreciation expense should be obtained from the cash flow statement (CFS), where it is treated as a non-cash add-back.
If deprecation is consolidated with amortization, simply copy the D&A amount in the filing and use the search function to find the footnotes that break out the precise depreciation expense amounts.
To calculate capital expenditure (Capex), subtract the current period PP&E from the prior period PP&E and then add depreciation.
The reason that depreciation is added back is attributable to the fact that depreciation is a non-cash item.
Because of the guidelines set by accrual accounting reporting standards, depreciation expense must be recognized on the income statement (and usually embedded within COGS and Opex).
While depreciation expense reduces the carrying value of fixed assets (PP&E) on the balance sheet, there is no actual cash outlay.
Hence, the depreciation expense is treated as an add-back in the cash from operations (CFO) section of the cash flow statement (CFS) to reflect that no real cash outlay occurred.
The current period PP&E can be calculated by taking the prior period PP&E, adding capital expenditure (Capex), and subtracting depreciation.
If the formula is rearranged to solve for capital expenditure (Capex), the value of a company’s capex for a given period can be determined.
The capex formula subtracts the ending PP&E by the beginning PP&E balance, and then adds depreciation.
Capital Expenditure (Capex) = Ending PP&E – Beginning PP&E + DepreciationTherefore, the prior year’s PP&E balance is deducted from the current year’s PP&E balance.
Why? The difference between the prior and current period PP&E represents the change in PP&E.
Since the increase or decrease in PP&E reflects the Capex spend, the annual depreciation recognized in the same period is added back because the expense is a non-cash item.
There are two different types of classifications that capital expenditure (Capex) is categorized into:
Growth capital expenditures and revenue growth are closely tied, as along with working capital requirements, capex is grouped together as “reinvestments” that help drive growth.
Hence, if growth capex is expected to decline and the percentage of maintenance capex increases, the company’s revenue should decrease from the reduction in reinvesting.
Barring unusual circumstances, it would be unreasonable over long-term time horizons for revenue growth to sustain itself (or increase) if the allocation of resources towards reinvestments has been decreasing.
The trend in the growth of capex must match revenue growth for projections to be reasonable.
As a company reaches maturity and the growth rate slows down to a sustainable rate (i.e., the company can grow at this rate perpetually), the ratio between depreciation and capex should converge towards 100%.
The convergence over time is attributable to how the majority of the spending becomes comprised of maintenance capex in tandem with the gradual diminishing of growth opportunities at some point in the lifecycle of the company.
Once a company’s growth begins to stagnate noticeably, a higher proportion of its total capex spend should shift toward maintenance capex.
In periods of economic expansion, the percentage of growth capex also tends to increase across most industries (and the reverse is true during periods of economic contraction).
In terms of building a complete 3-statement financial model, taking the time to assess historical capital expenditure levels properly and projecting future capex accordingly is a critical step.
We’ll now move on to a modeling exercise, which you can access by filling out the form below.
Suppose a company has revenue of $60.0m at the end of the current period, Year 0.
The growth rate of revenue is going to be 10.0% in the first year and ramp down by 2.0% each year until it reaches 2.0% in Year 5.
In terms of historical values for Year 0, the maintenance capital expenditure was $1.2m, while the growth capex was $1.8m. We can see that the total capex comes out to $3.0m in Year 0.
Moving onto the assumptions, maintenance capex as a percentage of revenue was 2.0% in Year 0 – and this % of revenue assumption is going to be straight-lined across the projection period.
For example, the maintenance capex in Year 2 is equal to $71.3m in revenue multiplied by 2.0%, which comes out to $1.6m.
In contrast, growth capex as a percentage of revenue is assumed to have fallen by 0.5% each year. Since the growth rate was 3.0% in Year 0, the percent assumption in Year 5 will have dropped to 0.5%.
The reasoning behind this assumption is the need to align the slow-down in revenue with a lower amount of growth capex.
Once those two metrics are filled out for the entire forecast, they can be added together for the total capital expenditures for each year.
The total capex decreases as a percentage of revenue from 5.0% to 2.0% by the final year.
There are two additional assumptions listed below the maintenance vs. growth calculation area:
If we have the total capital expenditures and depreciation amounts, net PP&E can be computed, which is what we’re working towards.
In the historical period (Year 0), the ratio between depreciation and capex, expressed as a percentage, came in at 66.7%.
Since we’re aware that the depreciation to capex ratio should gradually shift towards 100% (or 1.0x), we’ll smooth out the assumption to reach 100% by the end of the forecast.
For each year, the formula for the assumption will be equal to the prior % capex value plus the difference between 66.7% and 100.0% divided by the number of years projected (5 years).
After doing so, we can calculate 6.7% as the amount added each year. To confirm, we can see that depreciation and total capex were both $2.0m in Year 5.
In the final two steps, we’ll project PP&E and then back out the implied capital expenditure amount using the formula mentioned earlier.
Ending PP&E = Prior Period PP&E + Capex – Depreciation ExpenseFor example, in Year 1, the prior PP&E was $25.0m while capex was $3.0m and depreciation is $2.2m. Upon entering them into the formula, we get $25.8m as the current period PP&E balance.
Once repeated for each forecasted year, the implied capex (as a check) can be calculated by the change in PP&E (i.e., the difference between the current and prior period PP&E) and adding back the depreciation.
So in Year 5, the ending PP&E balance remains at $26.9m (i.e. net change of zero), while the depreciation expense is $2.0m, meaning the implied capital expenditure (capex) is $2.0m.
Enroll in The Premium Package: Learn Financial Statement Modeling, DCF, M&A, LBO and Comps. The same training program used at top investment banks.
