## What are Capital Expenditures?

**Capital Expenditures (Capex)** refer to the investments made by a company into long-term assets to help facilitate growth. For the vast majority of companies, Capex is one of the most significant outflows of cash that can have a major impact on their free cash flows.

- What is the definition of capital expenditures?
- How does Capex differ from operating expenses (Opex)?
- What is the difference between maintenance and growth Capex?
- As a company matures, how does the relationship between depreciation and Capex change?

Table of Contents

## How to Calculate Capital Expenditures (Capex)

In terms of building a complete 3-statement financial model, taking the time to properly assess the historical capital expenditures levels and projecting future Capex accordingly is a critical step.

The distinct feature of Capex (i.e., the purchase of PP&E) that differentiates it from direct costs and operating expenses is the accounting treatment on the financial statements.

Unique to Capex, the resulting long-term assets are anticipated to provide benefits to the company for more than one year.

So in an effort to match the expenses with the associated revenues during the same period, the value of the acquired PP&E is expensed via depreciation on the income statement as opposed to being treated as a one-time, immediate cash outflow on the date incurred.

The expenditure is thus spread across the asset’s useful life, which is an estimate of how long the asset is considered to be “useful” and capable of producing economic benefits.

The actual full cash outflow related to Capex is captured in the cash from investing section of the cash flow statement. On the assets of the balance sheet, the Capex amount will be captured as an increase to the PP&E balance and be reduced by the non-cash depreciation expense.

## Maintenance vs. Growth Capex

Capital expenditures include the purchase of new fixed assets and repairing/upgrading existing long-term assets. Listed below are some common examples:

**Property:**Buildings, Land**Equipment:**Transportation Vehicles, Machinery, Office Desks/Chairs**Hardware:**Computers, Laptops, Phones**Software:**CRM, ERP, Cybersecurity

There are two classifications that capital expenditures can fall under:

**Maintenance Capex:**The required ongoing expenditures of a company to continue operating in its current state (e.g., repair of broken equipment, periodic system updates)**Growth Capex:**The discretionary spending of a company related to new growth strategic plans to acquire more customers and increase geographic reach

Maintenance Capex involves mandatory spending to continue operations and is considered to be the spending associated with sustaining the current level of revenue and profit levels.

If not replenished, the ongoing operations wouldn’t be able to continue, which would negatively impact its performance.

On the other hand, growth Capex is when a company undertakes discretionary investments to increase its revenue and profits beyond historical levels.

This usually entails grabbing more market share, geographic expansion, introducing new product lines, etc.

## Capex and Growth Lifecycle Relationship

Growth Capex 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%.

This 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 noticeably stagnate, a higher proportion of its total Capex should shift towards maintenance.

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 an economic contraction).

## Capital Expenditures Formula

The current period PP&E can be calculated by taking the prior period PP&E, adding capital expenditures, and subtracting depreciation.

If the formula is reorganized to solve for capital expenditures, the value of a company’s Capex for a given period can be calculated using the formula below.

## Capex Formula

- Capital Expenditures = Current Period PP&E – Prior Period PP&E + Depreciation

Here, the prior year’s PP&E balance is deducted from the current year’s PP&E balance.

The difference between prior and current period PP&E represents the change in PP&E, and the depreciation amount from the same period is then added back.

## Capital Expenditures Calculator – Excel Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

## Capital Expenditures (Capex) Example Calculation

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 the historical values for Year 0, the maintenance capital expenditure is $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, the 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 % assumption in Year 5 will have dropped down 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.

As we can see from the completed output, the total Capex decreases as a % 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:

- Year 0 Depreciation = $2.0m
- Year 0 PP&E, net = $25.0m

If we have the total capital expenditures and depreciation amounts, the net PP&E can be computed, which is what we’re working towards.

## Depreciation-to-Capex Ratio Analysis

In the historical period, depreciation as a percentage of Capex came in at 66.7%.

Knowing the depreciation-to-Capex ratio should gradually shift towards 100% (or 1), we’ll smooth out the % CapEx 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 being added each year.

Note how in Year 5, depreciation and total Capex are both $2.0m.

In the final two steps, we’ll project PP&E and then back out the implied capital expenditure amount using the formula we discussed earlier.

The ending PP&E balance is equal to the prior period balance plus Capex (increase to PP&E) minus depreciation.

For example in Year 1, the prior PP&E is $25.0m while Capex is $3.0m and depreciation is $2.2m. Upon entering them into the formula, we get $25.8m as the current period PP&E balance.

After this is 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 change in PP&E is zero while depreciation is $2.0m, meaning Capex is $2.0m.

For each period, we can compare the implied Capex and total Capex values to confirm the two values are equivalent.