Capital expenditure, or CapEx, is the money spent by a company on buying, improving and maintaining physical assets, including buildings, machinery and property. CapEx is often a major component of a company’s expansion efforts, though large companies with existing businesses may also have substantial capital expenditures strictly from the maintenance and upgrading of their existing physical assets.
Capital Expenditure & Accounting
In accounting terms, CapEx covers any funds spent to either purchase new physical assets or improve existing ones. Any CapEx on new or existing physical assets is ‘capitalized’ for accounting purposes, which means that the cost in accounting terms is spread out over the useful life of the asset. Funds spent to maintain an existing physical asset in its current condition are spent in that year for accounting purposes.
CapEx is noted in the investment section of a company’s cash flow statement, and can be listed in a variety of different ways. These should be contrasted with operating expenses, or OpEx, which cover the funds that are spent to maintain revenue generating activities, such as the employees and electricity that it takes to operate a factory.
Capital Expenditure, Industry Sectors and Company Composition
The importance of capital expenditure to a company will vary depending on the type of industry that the company operates in. For example, the oil and gas industry has a very high rate of CapEx as a result of the vast amount of complex machinery that is required to find, extract, transport and refine petroleum products.By contrast, many service sector industries require little capital expenditure, often limited to office space and equipment for their employees to operate in and with.
The relative importance of CapEx to a company’s operations will have a major influence on that company’s finances and overall structure. Large amounts of capital require their own management and oversight, including technical specialists to maintain and supervise the physical assets.
Large amounts of capital will also mean that the company will have a large book value based on the physical assets that can be sold in the event of a liquidation, which will often be matched by a larger proportion of debt that is secured by the physical assets.
Capital Expenditure & Company Valuation
Capital expenditure is used in a number of important company valuation metrics, the most important being various ratios of cash flow to CapEx.
Companies with little cash flow compared to capital expenditure will struggle to maintain their existing physical assets, and will find it difficult to successfully expand operations by upgrading existing physical assets or purchasing new ones.
In particular, industries that rely on extensive capital expenditure to maintain competitive operations will find it extremely difficult to maintain a strong market valuation relative to their peers if they are failing to generate adequate cash flow to maintain an industry standard of capital expenditure.
Companies may turn to the debt markets for periodic imbalances between temporary cash flow shortages and capital expenditure requirements, but ongoing imbalances between cash flow and CapEx are usually a strong signal that a company is facing severe structural problems that will drastically reduce their valuation.
Capital Expenditure and Trading
Capital expenditure is used in fundamental analysis to attempt to identify a company’s ‘true value’ compared to its current market value. Traders who practice fundamental analysis should familiarize themselves with the concept of CapEx and the various key associated ratios that are used in valuation.
CapEx is generally used comparatively by referencing industry standards and the capital expenditure of similar companies. However, capital expenditure can also be used as a stand-alone metric when analyzing the inner-workings of a company by considering how effectively they use their existing capital to generate revenues.
Capital expenditure is an essential component in any fundamental analysis of a company’s value. While all companies will have some capital expenditure that is important to valuation efforts, for certain industries it may be the key metric that determines a company’s valuation relative to its competitors.
How certain asset-heavy companies spend their capital can often be the major determinant of their market valuation, as their capital expenditure will determine the revenues that the companies are able to generate in the future.