Capital Spending: Understand The Basics

Capital spending or capital expenditure are funds that a company uses to purchase, upgrade, and carry out the maintenance of long-term physical assets. These assets are fixed and non-consumable, which include plants, infrastructure, property, equipment, or technology. CapEx is used for undertaking new projects or investments and also includes expenses on fixed assets like purchasing new equipment, building a new factory or warehouses, repairing a roof, etc. The purchase of intangible assets like a patent or a license also falls under the scope of capital expenditure. Companies make financial spending of this sort with the aim to increase the range of their operations and gain economic benefit from it.

Now that you know what is capital spending, here’s how to calculate net capital spending.

Capital Spending Formula

CapEx = ΔPP&E + Current Depreciated Value

• CapEx is capital expenditure/capital spending
• ΔPP&E is the changes in the long-term assets or PP&E (Property, Plant, and Equipment)

What does capital spending indicate?

Capital spending is the expense that a company capitalizes on; it is put as an investment on the balance sheet rather than an expenditure on the income statement. To capitalize on an asset, a company has to consider the duration of utility that can be placed on the asset until it ceases to deliver economical results and then spreading out the cost of expenditure over this useful life of the asset. Hence, calculating the capital spending gives an idea about the investment that a company has made in its existing and new fixed assets to maintain and keep the business growing.

The industry in which a company operates significantly determines the capital spending that the company is going to have. Hence, certain industries such as telecommunication, manufacturing, utility, and oil exploration and production that are highly capital intensive will have high levels of capital expenditure as well.

The capital spending or CapEx are disclosed in the cash flow statement of the company for an accounting period. As the capital spending of a company makes a substantial impact on its short-term and long-term financial standing, making the right CapEx decisions is crucial to maintain the financial health of a company. The capital expenditure stats over the years are also used by many companies to show investors that the company is very firm on investing in the growth of the business. It is also highlighted as acquisition expense and purchases of PP&E.

Capital expenditure can also be found in the income statement and balance sheet of the company.

Here’s how to find the net capital spending of a company for the current period:

1. Find the amount of depreciation expense for the current period from the income statement.
2. Find the PP&E line-item balance for the current period from the balance sheet.
3. Now, find the prior-period PP&E balance of the company and take the difference from the current period. This will give you the change in the company’s PP&E balance.
4. Once you have the change in the PP&E balance, you can add it to the depreciation expense for the current period. The result will be your CapEx spending of the company for the current period.

Company Analysis Ratios with CapEx Metric

The CapEx metric can be used for more than just analyzing the investment of a company in the fixed assets. Here’s how the CapEx metric helps to determine other ratios for company analysis.

CF-to-CapEx ratio

The CF-to-CapEx (Cash-flow-to-capital-expenditures) ratio is a good indicator of the company’s performance. The ratio gives an insight to analysts about the amount the company is investing in capital expenditures, such as PP&E. The CF-to-CapEx ratio shows the ability of the company to purchase long-term assets using free cash flow. As companies go through the cycles of large and small capital expenditures, the ratio will fluctuate. When the ratio is greater than one, it indicates that the company is generating enough cash flow to acquire the assets. However, if the ratio is low, it could mean the company lacks sufficient funds to purchase its capital assets.

The formula to calculate the CF-to-CapEx ratio is:

CF/CapEx = Cash Flow from Operations / CapEx

Note: As the CF-to-CapEx ratio is specific to the industry, it should be compared against the ratio of another company with similar capital spending requirements.

FCFE

FCFE stands for free cash flow to equity. It gives a measure of the amount of cash that can be potentially distributed to the equity shareholders after the payment of all expenses, debts, and reinvestments.

The formula to calculate FCFE with capital expenditure is:

FCFE = EP − (CE−D) × (1−DR) – ΔC × (1−DR)

• EP is the earnings per share calculated by dividing the company’s profit by the outstanding share of its common stock
• CE is the capital expenditure
• D is depreciation
• DR is the debt ratio indicating the percentage of assets offered via debt
• ΔC is the change in net working capital

A lower FCFE indicates a higher capital spending for a firm.

Importance of Capital Spending

Capital spending is important for firms to maintain their PP&E as well as to make data-driven investments in new assets or technology for further business growth. The decision that a firm makes today for its capital spending extends into the future. This means that the present range of production or manufacturing activities of a firm is the result of the capital spending decisions made by the firm in the past. Hence, the decisions made now will have a significant impact on the future activities and growth of the company.