CapEx vs OpEx explanation

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.

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