Capital Expenditure Formula

What is Capital expenditure?

Capital expenditure is any expenditure that is done for purchasing, developing, or maintaining a fixed asset. Such assets should have a beneficial life of a year or more for the company. Some examples of capital expenditure are buying land for expansion, a major renovation of existing factory premises, buying new plants and machinery or vehicles for business use, etc. Capital expenditures are done for the long-term betterment of a business organization. They give strength to a company’s existing infrastructure by improving it, and sometimes maintaining it. They are important to build capacity, sustain and survive the competition and get ahead of them.

We can easily find the capital expenditure expense of a company over a period of time by going through its cash flow statement. Capital expenditures are a form of investment for the company. Hence we find its details under the investing activities in the cash flow statement. Furthermore, there is a capital expenditure formula too for finding out the capital expenditure over a financial period.

Capital Expenditure Formula

The following is the formula for finding out the capital expenditure:

{PPE (for current period) less PPE (for the period immediately before this} + Depreciation/Amortization for the present financial period

PPE in the formula stands for Property, land, and equipment.

The depreciation amount in the formula is the amount that is charged to the Income statement for recording the reduction in the value of a tangible asset with regular usage. Any asset, be it a machine, or a vehicle, or a computer, loses value with every passing financial year. We record this reduction in value as depreciation in the Income statement to pass it off as expenditure in that year. We reduce the value of the asset with the same amount in the Balance Sheet to show its actual current value as on the day of making the Balance Sheet. Similarly, we record the fall in the value of intangible assets too. Their value reduction is known as amortization.

Expenditure on an asset with a useful life of less than one year does not come under the category of capital expenditure. We do not capitalize on such expenditure. It will directly go in the Income statement as an expense. Hence, there will be no formula for such assets. And similarly, these expenses will not be part of the formula to calculate capital expenditure. 

How to Use the Capital Expenditure Formula?

In order to use the above formula, we need the Income statement and the Balance Sheet of the company for the current financial year. These financial documents can be easily taken from the website of the Securities and Exchange Commission (SEC) if the company is publicly listed.

The Balance Sheet will give us the opening and closing value of the property, plant, and equipment (PP &E) that the company has. We deduct the opening value of PPE from the closing value of PPE. This will give us the difference or the addition in PPE over the financial year.

Then we will take the amount of depreciation expense charged to these assets over the year from the Income statement. Another way is to take the accumulated depreciation figures for the two years. Then we reduce the accumulated depreciation amount from last year from the accumulated depreciation amount of the current year. This will give us the depreciation expense for the current year.

The final step is to add the difference in PPE over the two years and the depreciation expense over the year. This will give us the total amount of capital expenditure over the period. In simple words, the current PPE amount in the Balance Sheet is the sum total of last year’s closing amount of PPE and capital expenditure in the current year, adjusted for the depreciation expense.

Capital Expenditure Formula

Example

Let us understand how to use the capital expenditure formula with the help of an example. ABC Corporation had PP &E worth US$ 12500 at the end of the year 2020. The value of PP &E at the beginning of the same year was US$ 12000. The depreciation expense for the year ending December 2020 was US$ 3200.

Hence, net increase in PP &E over the financial year= US $ 12500 – US $12000= US $500.

Therefore, Capital expenditure over the financial year 2020= US$ 500 + US $3200= US $3700.   

Applications of Capital Expenditure Formula?

Big multinational corporations have complex capital expenditure schedules and financial statements. The capital expenditure formula is of use in preparing financial models for such companies. Also, the formula helps us to find the exact capital expenditure amount in the current financial period. This detail can help us to find the following ratios:

Cash Flow to Capital Expenditures Ratio

This ratio helps us to find out if the cash flow that the company is currently generating is sufficient enough to fund its capital expenditure or not. A ratio higher than one means the company can comfortably engage in capital spending. A company has two options in case the ratio is lower than one. It can either increase its cash flow or decrease its capital expenditures. Since it is not possible to increase the cash flows instantly, the company can decide to curtail its capital expenditure and bring the ratio under control. Or the other alternative to complete a good project is to look for external resources of funds. This would however depend upon the financial strength, existing quantum of debts, and debt servicing capacity.

Free Cash-Flow to Equity (FCFE)

FCFE gives us the amount of free cash available with the business that can be given to the shareholders. For finding out FCFE, first, we add the cash the company has from its operations and new debt if it has taken any. Then we deduct the capital expenditure amount and debt portion that it has paid back if any.

High capital expenditure will result in low FCFE and vice-versa. In some years in which capital expenditure is very high, the FCFE can even be negative. Alternatively, if the company wants to maintain surplus cash for giving it to its shareholders, it can automatically adjust its capital expenditure.  

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Sanjay Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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