WHAT IS CAPEX? CAPEX BASIC INFORMATION AND TUTORIALS

What is CAPEX?

Short Answer
CAPEX stands for ‘Capital Expenditure’ and represents the amount of money spent for investments carried out from a long-term perspective.

Through the production process, fixed assets are used up. The annual depreciation charge is supposed to reflect this wearing out. By comparing capital expenditure with depreciation charges, you can determine whether the company is:

• Expanding its industrial base by increasing production capacity. In this case, capital expenditure is higher than depreciation as the company invests more than simply to compensate for the annual wearing out of fixed assets.

• Maintaining its industrial base, replacing production capacity as necessary. In this case, capital expenditure approximately equals depreciation as the company invests just to compensate for the annual wearing out of fixed assets.

• Under investing or divesting (capital expenditure below depreciation). This situation can only be temporary or the company’s future will be in danger, unless the objective is to liquidate the company.

Comparing capital expenditure with net fixed assets at the beginning of the period gives you an idea of the size of the investment program with respect to the company’s existing production facilities. A company that invests an amount equal to 50% of its existing net fixed assets is building new facilities worth half what it has at the beginning of the year. This strategy carries certain risks:

• that economic conditions will take a turn for the worse;
• that production costs will be difficult to control (productivity deteriorates);
• technology risks, etc.

The theoretical relationship between capital expenditures and the cash flow from operating activities is not simple. New fixed assets are combined with those already on the balance sheet, and together they generate the cash flow of the period.

Consequently, there is no direct link between operating cash flow and the capital expenditure of the period.

Thus, comparing cash flow from operating activities with capital expenditure makes sense only in the context of overall profitability and the dynamic equilibrium between sources and uses of funds.

The only reason to invest in fixed assets is to generate profits, i.e. positive cash flows. Any other objective turns finance on its head. You must therefore be very careful when comparing the trends in capital expenditure, cash flow, and cash flow from operating activities. This analysis can be done by examining the cash flow statement.

Any investment strategy must sooner or later result in an increase in cash flow from operating activities. If it doesn’t, then the investments are not profitable enough.

Be on the lookout for companies that grossly overinvest, despite their cash flow from operating activities not growing at the same rate as their investments. Management has lost sight of the all-important criterion that is profitability.

All the above does not mean that capital expenditure should be financed by internal sources only. Our point is simply that a good investment policy grows cash flow at the same rate as capital expenditure.

This leads to a virtuous circle of growth, a necessary condition for the company’s financial equilibrium, as shown in graph (a) of Figure 1.5 below. Graphs (b), (c) and (d) of Figure 1.5 illustrate other corporate situations. In (d), investment is far below the company’s cash flow from operations.

You must compare investment with depreciation charges in order to answer the following questions:

• Is the company living off the assets it has already acquired (profit generated by existing fixed assets)?

• Is the company’s production equipment ageing?

• Are the company’s current capital expenditures appropriate, given the rate of technological innovation in the sector?

Naturally, the risk in this situation is that the company is ‘resting on its laurels’, and that its technology is falling behind that of its competitors. This will eat into the company’s profitability and, as a result, into its cash flow from operating activities at the very moment it will mostly need cash in order to make the investments necessary to close the gap vis-`a-vis its rivals.

The most important piece of information to be gleaned from a cash flow statement is the relationship between capital expenditure and cash flow from operating activities and their respective growth rates.

Lastly, ask yourself the following questions about the company’s divestments. Do they represent recurrent transactions, such as the gradual replacement of a rental car company’s fleet of vehicles, or are they one-off disposals?

In the latter case, is the company’s insufficient cash flow forcing the company to divest? Or is the company selling old, outdated assets in order to turn itself into a dynamic, strategically rejuvenated company?