Capex 101 — Investing for Growth

What is capex and why does it matter?

How well do you understand the concept of depreciation and capital expenditures (capex)? Can you relate it to your own business or another business owner?

It's a tough one even for seasoned finance pros.

This is the best explanation of capex I've ever come across (book revealed later):

What is capex?

Capex is money you spend on big-ticket purchases with an intended use for more than a year. Most companies have a dollar threshold at which they'll "capitalize" something (i.e. the "cap" in capex).

The goal is to spread these costs over the useful life of that asset. For example, you run a landscaping business and buy a commercial mower, you'll probably get 5 years of use out of that $5,000 mower, so you'll spread that out as $1,000 per year over 5 years instead of showing a $5,000 expense upfront.

It's an investment in your business that you intend to get a return on.

In this example, the $5,000 is capex (upfront amount) while the $1,000 over 5 years is depreciation (spreading the expense over the useful life).

Some examples of capex / depreciable items could include:

• Construction equipment
• Trucks, vans, or fleet vehicles
• Point-of-sale hardware for a retailer
• Office furniture or large fixtures in a store
• Forklifts, pallet racking, or warehouse equipment
• Treadmills, weights, etc. for gyms or fitness studios
• Computers, copiers, or any expensive IT equipment

Why you should care?

Investing in your business is important. When looking at a client, investment, or acquisition, I'm checking for 4 things:

• Deferred investment — Is the business underspending on physical assets? You can defer capital spending for a while but it catches you eventually. That fleet of run-down used U-Haul trucks will start to break down and you'll need to replace them. Consistent maintenance of physical assets will keep financial performance humming and avoid cash crunches from trying to replace everything at once.
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• Growth investments — You could argue that capex is split into: 1) maintenance capex; and 2) growth capex. The maintenance capex keeps your current assets running smoothly while growth capex would allow you to capture new revenue, lower costs through efficiency gains, add capacity etc.
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• Underlying earnings — This is most applicable to smaller businesses. If you have a business with ongoing capital needs (i.e. recurring vehicle or equipment purchases), don't just book those as regular expenses. Make sure they get recorded as assets on the balance sheet and spread those costs! You'll still get the upfront tax benefits and you'll have smoother, more accurate financial reports.
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• Cash flow planning — While the expenses are spread over several years, you still have to pay for these things upfront. That typically comes from cash on hand or taking out a loan. Make sure you're adequately planning for the cash investments needed in capex.

Depreciation might be a non-cash expense when it comes to the P&L and cash flow, but Warren Buffett likes to remind us that in the long-run, depreciation is a very real expense as we need to replace assets over time. Don't fool yourself into thinking your current base of physical assets will last forever!

How can you use this in your business?

A few guidelines when it comes to managing capital intensity...

• Benchmark it — There's great data out there covering industry capex and depreciation as a ratio to sales. It's a great way to benchmark whether you're potentially under or overspending on assets.
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• Don't be afraid of scratch math — Especially for those who aren't mathematically inclined, use back-of-the-napkin math to guide decision making. Run a quick payback calc: If a $10,000 tool saves $5,000 a year, then it pays for itself in 2 years. If you rent equipment
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• Separate maintenance vs. growth — This sounds complex but in reality, just ask yourself if the capital spend will replace an existing asset or add something new entirely. With that in mind, you can start planning out whether it's an investment you can afford right now or if it's best saved for another day.
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• Consider financing — As a business owner, I can't preach the importance of liquidity enough. Many banks have loan programs specifically for capital investments. [As a plug: we recently did a series on managing leverage and we're happy to help navigate this, just hit reply!]
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• Cash planning — Bake these planned investments into 13-week cash flow forecast (you’ve got one, right?) to see if you can afford the purchase. Don't forget to assess potentially higher operating costs with new equipment: insurance, skilled labor, maintenance plans, etc.

Takeaways — Capex is one part maintaining your assets and one part investing in future growth. For many business owners, their only familiarity with it was getting the business started. For owners with capital intensive businesses, it's part of their daily workload.

P.S. — As a bonus, here's a recent book review on Small Giants by Bo Burlingham. It's a great read and worth your time.