We've talked before about the definition of an expense in accounting, but there are more specific categories of expenditures that, as a small business owner, you should be familiar with. One of these is capital expenditures, or CAPEX. You'll want to have a good understanding of CAPEX not only for accounting purposes, but also to paint the best possible picture of your company's financial health in the eyes of your investors.
Obtaining and Maintaining Physical Assets
Capital expenditures occur when you purchase significant new physical assets for your company: things like big-ticket office equipment, machinery used to manufacture your product or property (like office space or a new factory). Upgrading existing physical assets can also count as a capital expenditure (think repairing machinery or building an addition on an existing property).
But this is where the "expenditure" part of "capital expenditure" can get a little confusing. CAPEX are not recorded as expenses in your accounting records. Since they have to do with acquiring substantial assets for your business, CAPEX are instead recorded as fixed assets. These assets are then recorded as expenses in installments over the course of the useful lifetime of said assets.
Let's clarify using an example. Say you're in the manufacturing business and you need to purchase a $10,000 piece of equipment to make a new product and expand your business. If the expected useful lifetime of this piece of equipment is 10 years, then you would charge $1,000 per year to your expenses (more specifically, you would charge it to your depreciation expenses account).
The Capitalization Limit
Spreading the fixed cost of a capital expenditure over the asset's useful lifetime, like in the example above, is known as capitalization. Companies that incur CAPEX normally have a capitalization limit in place that determines a threshold where an expense becomes classified as a capital expenditure. This can help ensure that the recordkeeping costs associated with tracking CAPEX stays under control.
Let's take a look at another example. If your company's capitalization limit is set at $5,000 and you purchase a piece of machinery for $4,999, then that would be recorded as an expense at the time it is incurred. If, however, a piece of equipment cost $5,001, it would be treated as a capital expenditure and recorded in the way we talked about above.
From an investor's perspective, your company's CAPEX are worth examining, both in relation to similar companies within your industry and in relation to your cash flow. Generally speaking, they would expect the level of CAPEX to be maintained at a certain level from year to year (at least in the case of a more established company); otherwise, it may seem like the company is not investing enough in its own growth or is not keeping up with industry developments.
Even if your company is not yet at a stage where big-ticket CAPEX are incurred on a regular basis, it's still important to have a clear understanding of this piece of the financial puzzle of your business.