CapEx versus OpEx.
Capital Expenditures versus Operating Expenditures.
There is a finance and accounting aspect
to the terms CapEx and Opex, as well as
a business model aspect.
Let's discuss both, and walk through some examples
of how the terms CapEx and OpEx are
used.
CapEx is Capital Expenditures.
OpEx is Operating Expenditures.
What these terms have in common
is the word expenditures, you are spending money, but
in different ways.
Capital Expenditures.
As a working definition of CapEx,
this is money spent by a business or organization
to acquire or upgrade fixed assets,
such as buildings, machines and equipment.
Operating Expenditures.
OpEx is used in different types
of financial conversations,
for example if you are discussing
the income statement you could discuss
whether a cost belongs to COGS (Cost Of Goods Sold)
or in OpEx (Operating Expenses),
these are different sections of the income statement.
In discussing CapEx versus OpEx,
we are making a different comparison.
If CapEx is the upfront investment to buy a fixed asset,
then a working definition of
OpEx is the ongoing spending
to keep the fixed asset running.
Here are some examples.
If you are in the real estate business,
a new roof for the building is very likely to
qualify as CapEx spending,
while window cleaning is OpEx.
If you run a lab, buying new test equipment is CapEx,
and the maintenance of that equipment
is OpEx.
If you are in IT, buying servers
for your own datacenter is CapEx,
using an external
cloud service for a monthly fee is OpEx.
There are many more examples,
please share them in the comment section
below this video
if you have any good ones.
For an expenditure to be considered as CapEx,
you have to own an asset.
There is a threshold level for expenditures
to qualify as CapEx:
there must be a useful life
of more than one year,
and the asset value must be more than a minimum amount.
I have worked with a company
where this minimum was $2500,
and others where it was $7000.
Please check with the finance department
of your company
on what your minimum level is.
Let's now take some less obvious examples,
where you would need to evaluate and argue
a case whether CapEx (capitalization)
would be justified.
How about that part of maintenance
where you are improving
the performance of a machine
and increase its capacity?
What about software developed for internal use?
What about the development phase of R&D?
You could argue in all three cases
that future economic benefits are generated
by these projects,
and according to the matching principle in finance
it would be appropriate to capitalize
these costs, and subsequently depreciate or amortize
these assets over their useful life.
Each of these cases will have to be evaluated carefully
against current US GAAP or IFRS
rules (depending on where your company is listed),
and you will have to meet very strict
criteria to apply a CapEx treatment.
Why would anyone want to go through this trouble
to analyze the appropriateness of CapEx versus
OpEx treatment?
The answer to this is: it possibly has a significant effect
on your financial statements!
How does CapEx affect the financial statements?
Let's take a look at the balance sheet,
the income statement and the cash flow statement,
when we answer the question
"does this expenditure qualify
for CapEx (it meets the capitalization
criteria) or it does not qualify as CapEx?".
First of all, the CapEx spend is a cash outflow
recorded in "Cash From Investing Activities".
On the balance sheet, it gets accounted for as an asset,
in the Plant and Equipment category.
Over the years of its useful life,
the asset gets depreciated,
and the depreciation charge
hits the income statement or P&L
in each of the years of the assets' economic life.
I will link to my video about deprecation
if you are interested
in learning how that works.
How does OpEx affect the financial statements?
The expenditure goes
straight into the income statement as a cost.
On the cash flow statement, that same spending
is recorded as a cash outflow in "Cash From
Operating Activities".
To stay with the question "does this expenditure qualify
for CapEx (it meets the capitalization
criteria) or does it not qualify as CapEx?",
let's look at the financial effects, and make
a relative comparison
between the CapEx and OpEx columns.
On the balance sheet, assets tend to be higher
under CapEx treatment than under OpEx treatment.
Liabilities will also be higher,
as what we own in assets has to be financed
by what we owe in liabilities:
either borrow money to fund the asset,
or raise new equity.
Alternatively, if you don't want total assets
and total liabilities to go up, you could
invest in Plant and Equipment
and take an offsetting lower cash balance for granted.
On the income statement,
year 1 cost will be lower
under a CapEx treatment, and profit
will therefore be higher.
In subsequent years depreciation of the asset kicks in
if you have taken a CapEx treatment.
Costs will be higher, and profit lower.
On the cash flow statement, CapEx is a cash outflow
in Cash From Investing Activities,
while OpEx is a cash outflow
in Cash From Operating Activities.
In many companies,
CFOA usually tends to be a net cash inflow
and CFIA a net cash outflow,
so under a CapEx treatment
CFOA would be a higher inflow
and CFIA would be a larger outflow
i.e. a larger negative number.
For ratios, ROA or Return On Assets
is undecided between CapEx and OpEx.
In year 1, due to the higher profit
under a CapEx treatment,
the numerator in the ROA
equation (profit) will be higher.
As CapEx treatment increases assets, the denominator
of the ROA calculation (assets) will also
be higher.
You would have to take specific amounts
to build the scenarios for your specific situation.
If you want to learn more about ROA and related ratios,
please watch the related video on
that topic.
Now, let's discuss the business model aspect
of CapEx versus OpEx.
Out of the first three examples that we have discussed
earlier on in this video, you only
really have a choice which way to go
in the third example.
Do you go for the upfront CapEx investment
to own servers
for your datacenter, where
you are unsure how much capacity
you will actually need,
or do you pay a monthly OpEx
fee for an external cloud service
where it's pretty much "pay as you go" and
"spend what you use"?
I can't give you a "one size fits all" answer
to this question,
it's really something that
an IT manager and a finance manager
should analyze together.
Risk and scale should be part of this conversation.
The evaluation is a variation of the age-old
"own versus use", "buy versus rent",
"buy versus lease" discussion, which is more relevant
than ever before in these days of ubiquitous
digital devices and tools, disruption of mobility models
through Uber and others, and disruption
of the travel and leisure models through Airbnb.
Thank you very much for watching!
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