Capital expenditure, also known as capital expense (CAPEX) is defined as the expenses used by companies in acquiring assets for a long term, or making renovations or upgrades which will not be exhausted in a short while.
For example, in textile industry, the expenses for the machines and their repairmen are the capital expenditures, as well as the buying of more machines to expand the company.
The CapEx of a company is exempt from the tax deductions. They are added to a company’s assets, whose value depreciates with each passing year.
Capital expenses are used by businesses to achieve a significant return on investment (ROI) and to initiate future cash flow.
Importance of Capital Expenditure
CapEx is used extensively by businesses in the cash flow statement. The decisions regarding capital expenditures are the most important decisions made by a company because they provide the structure for future activities. Once a decision is made for CapEx, it becomes irreversible. Therefore, great care must be taken to make the right capital investment decision. It is important for a company to determine whether its expenses should be capitalized or expensed.
Capital expenditures are for long-term purposes; hence, their effects are extended over a period of time. This factor is used by investors to determine if a company is highly efficient or not, if it is under investing, if it has higher future spending and if the margins are low.
What is Included in Capital Expenditure?
The expenses in capital expenditure are non-recurring in nature. They are utilized to gain physical assets such as:
- Start up of a new business
- Restoring the company’s property
- Updating the company’s property
- Adapting the company’s property to a different use
- Updating an asset belonging to the company
- Obtaining fixed assets
- Repairing assets of the company
Ratio of Cash Flow to Capital Expenditure
The cash flow to capital expenditure ratio is a very important ratio which describes the ability of a company to obtain assets for long term using the free cash flow.
The ratio of cash flow to capital expenditure (CF/CapEx) is given by:
CF/CapEx=(Cash flow from operations)/(Capital expenditures )
If the CF/CapEx ratio increases, it means that the company is financially stable to afford assets, and hence, can be on its way to future growth.
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