Investing tips: What is capital expenditure (Capex)?

It is important to calculate how much a firm will spend on capital expenditure as this will impact its free cash flow.

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A firm’s capital expenditures (capex) are funds that it requires to spend in order to maintain or grow its business operations. This includes, for example:

  • Maintenance or upgrades to physical property: This is the amount of money which the firm is required to spend to prevent property degradation or indeed improve the quality of its store locations.
  • Investment Projects: This is money which the firm spends to grow its business operations in the future. Investment projects may include the construction of warehouses, new stores, technological innovation or the building of stores.
  • Expansion plans: The firm may spend money establishing joint ventures or working with business partners in different parts of the world to grow its business.

Importance of Capex

It is important to calculate how much a firm will spend on capital expenditure as this will impact its free cash flow. A firm’s free cash flow is the money which it can distribute to owners after all expenses have been paid. The formula to calculate free cash flow is:

= Net income Depreciation & Amortisation – Capital Expenditures.

The amount of money of which the firm spends on capital expenditures will have a major impact on the firm’s ‘actual’ earnings. One of the most determining factors that affect how much a firm is required to spend on capex is the industry in which it operates.

Firms which are in the credit card industry or beverage industry are considered to have low ongoing capital expenditures. There is minimal maintenance required to keep their business going. However, firms which operate in the utilities sector or oil and gas, have extremely high capital expenditures as they need to outlay large sums to maintain their business. Such businesses are generally more vulnerable to downturns in the business cycle.

Nuances related to Capex

The amount that is generally subtracted for capital expenditures is the capital expenditures required for the maintenance of the firm’s operations. Investment and expansion projects will grow the firm’s future earnings and are therefore not deducted as general capital expenditures. Usually, business owners will take an average of the maintenance capital expenditures in the last 4-5 which the company has incurred and subtract that from net income, depreciation & amortisation.

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