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Capital Expenditures

How the Foresight financial models calculate capital expenditures and depreciation

What are capital expenditures and depreciation?

Capital expenditures (CAPEX or CapEx) are funds used by a company to acquire, upgrade, and maintain physical assets such as property, industrial buildings, or equipment. This type of spending is typically essential for sustaining and enhancing a company's operations and competitive position. Unlike routine operating expenses, capital expenditures represent significant investments aimed at improving a company's future earning capacity. These expenditures are capitalized, meaning their value is recorded as an asset on the balance sheet rather than an immediate expense on the income statement. This capitalization reflects the expectation that the benefits of the expenditure extend over multiple years. CAPEX can often be broken down into:

  • Growth CAPEX: capital expenditures that allow the company to grow in the future
  • Maintenance CAPEX: capital expenditures that maintain the value (cash flow generation potential) of an existing asset

Depreciation is the process of allocating the cost of a tangible asset over its useful life. In essence, it is an accounting technique that reflects the consumption of an asset's economic value through its operational life. Depreciation enables companies to match the cost of an asset with the revenue it generates, adhering to the accounting principle of matching expenses with revenues in the periods in which they are incurred. This method smooths out large expenditures over time, offering a more accurate picture of a company's financial performance and operational efficiency.

While depreciation affects the income statement and the balance sheet, it's crucial to note that it does not impact cash flow directly. On the income statement, depreciation is recorded as an expense, reducing the net income for the period. On the balance sheet, it reduces the book value of the asset through accumulated depreciation, reflecting the asset's declining value over time.

The separation between depreciation and actual cash flow is a common point of confusion. Depreciation decreases net income, but because it's a non-cash expense, it's added back to net income in the cash flow from operations section of the statement of cash flows. This adjustment reconciles the net income reported on the income statement with the net cash flow from operating activities, providing a clearer view of the company's cash generation capabilities.

Types of Assets Typically Depreciated

Depreciation applies to tangible assets that have a useful life longer than one year and are used in the operation of a company. These assets degrade over time due to use or obsolescence. Commonly depreciated assets include:

  • Buildings: Structures owned and used by a company, excluding the land on which they stand.
  • Machinery: Equipment used in manufacturing or production processes.
  • Vehicles: Cars, trucks, and other transport equipment used for business operations.
  • Office Equipment: Computers, printers, and furniture used in the company’s offices.
  • Fixtures and Fittings: Items attached to a building but not part of it, like lighting systems or shelving.

Typical Depreciation Periods

The useful life of an asset varies widely depending on the asset type:

  • Buildings: 25 to 40 years, reflecting their longer usability.
  • Machinery and Vehicles: 5 to 10 years, due to quicker wear and tear or technological obsolescence.
  • Office Equipment and Fixtures: 3 to 5 years, as they may become obsolete more rapidly due to technological advances.

These periods are guidelines, and actual depreciation schedules can vary based on industry standards, regulatory requirements, and company-specific factors.

Common Depreciation Methods

Several methods are used to depreciate assets, each intended to reflect the particular usage of an asset over time:

  • Straight-Line Depreciation: The most straightforward approach, dividing the cost of the asset evenly over its useful life. This method assumes the asset provides equal value each year.
  • Declining Balance Depreciation: A more accelerated depreciation method that applies a constant rate to the asset's remaining book value each year, resulting in higher expenses in the early years.
  • Units of Production Depreciation: Ties depreciation to the asset's usage, allocating cost based on the actual output or usage during the period. This method is ideal for machinery whose wear depends more on usage than on time.
  • Sum-of-the-Years'-Digits Depreciation: Another accelerated method that depreciates assets more heavily in the early years. It calculates annual depreciation by multiplying the asset’s depreciable base by a series of fractions.

The choice of method impacts financial reporting and tax obligations, making it crucial for companies to select the one that most accurately reflects their assets' usage patterns and financial strategy.

How to use

The Standard Financial Model, Starter Financial Model, and Runway Budgeting Tool all share a core component in the Forecast sheet that handles the calculations of capital expenditures and depreciation using a straight-line depreciation method for all capital expenditures.

In the core revenue and expense section on the Forecast sheet, any line can be assigned to CAPEX is summed into the total new CAPEX for that period. The input that defines the depreciation period is Depreciation, straight-line for N months on Get Started.

How it works

There is one input on Get Started called "Depreciation, straight-line for N months" that sets the number of months over which the CAPEX is depreciated over using straight-line depreciation. Straight-line just means that the capital expenditure depreciates the same per period, so you can calculate the depreciation per period as CAPEX / time period.

There are many different methods for depreciation than straight-line, and you may find yourself wanting to create depreciation schedules that depreciate different assets over different periods of time and using different depreciation methods. This is not prebuilt into the models, but can be added by expanding the depreciation schedule on the Forecast sheet and linking them into the core revenue and expense lines and selecting depreciation in the category dropdowns.

CAPEX is reported in the Cash Flows from Investing section in the period when the expense is made (not the Income Statement), and the total sum of capital expenditures over time is typically reported as Property, Plant, and Equipment (PPE). Depreciation is reported under other income and expenses on the incme statement, and the total sum of all depreciation over time is reported alongside PPE on the balance sheet.

CAPEX increases PPE, depreciation reduces PPE.

PPE can be reported in a few different ways on balance sheets:

  • Three lines: (1) PPE, representing the sum of CAPEX (purchases of PPE) over time, (2) Accumulated Depreciation, representing the sum of all depreciation expenses over time associated with that PPE, and (3) Total PPE, the sum of the two above. PPE will be reported as a positive number, Accumulated Depreciation as either a positive or negative number depending on whether the report is using positive normal format, but remember that accumulated depreciation will reduce total PPE.
  • One line: Net PPE, representing the sum of all CAPEX and accumulated depreciation.

The calculations on the Forecast sheet calculate the depreciation per period and the balance of PPE at the end of each period:

  • Property, Plant and Equipment, net of Depreciation, beginning of period: accumulated capital expenditures + depreciation, at beginning of period

  • New Capital Expenditures (CAPEX): capital expenditures during period

  • Depreciation: Using assumption from Settings, straight-line depreciation for all capital expenditures

  • Depreciation: Any additional depreciation expenses outlined in the main Expenses section above. This can be used to create a custom depreciation schedule, for example.

  • Property, Plant and Equipment, net of Depreciation, end of period: accumulated capital expenditures + depreciation, at end of period

  • Accumulated Capital Expenditures: Total capital expenditures to date, at end of period

  • Accumulated Depreciation: Total depreciation to date, at end of period

  • Value of Newly Fully Depreciated Assets: assets which reach full depreciation during this period, positive number

  • Capital Expenditure Depreciation Basis: accumulated capital expenditure, less any fully-depreciated assets, at time of full depreciation. This is used for the calculation of depreciation. The depreciation calculation could be done clearer using cohorts, which would allow for different average depreciation schedules for assets acquired at different times, or could be broken out into different depreciation schedules for different assets, but a simpler method is used in this model for efficiency.

How to enter depreciation manually

You can also choose to not use the prebuilt depreciation schedules and build you own. You can generate them in the core revenue and expense section on Forecast using the drivers, entering in your assumed depreciation manually, or by building your custom calculations elsewhere in the model and linking them into the lines.

A typical use of this would be to build different depreciation schedules for different assets using other depreciation methods (often methods that accelerate depreciation, meaning it is higher earlier on and lower later on) with different useful lives.