You will get clarity in capital expenditure for a company how to categorise it and methods for approve a capex in this post.
An expenditure incurred to apperciate your networth it said to be capital expenditure. Simple to remind you is a house, car, a mobile etc.
In factories and plants, expenditures made for machineries and equipements. Categorisation of this expense as revex or capex is always a disbute. Because for people who are in factories or plants as superivisors / managers have different opinion. They will say book it capex if revex budget is not available. In many companies, revenue expenditures are defined. No body can book in excess of budget.
So, Capex booking in financial books is so much complicated for a professional from the begining of the approval. Many decisions are made at the time of statuory audit.
First you have to clear that
- Capex is an investment for the company.
- Expense budget to be given based on the project not based on amount.
- Return of investment to be montiored.
Return on Investment – ROI
So Return on investment is the measure to approve the capex. So what are the things to be known for ROI?
Initial cash flow : In my perspective, investment in capital expenditure is not to locked or controlled based on initial investment. Return on this investment is to be the measure for that. So, determine how much capital required for a business or project to explained in deail.
Forecast cash flow from the investment : Find out the future expected cash flow for the company out of this project is main function. It may be defined in two terms
- Free cash flow or
- Profit on investment
Determine the minimum rate of return for the company: Sometimes, rate of return will be less than the profit percentage of a company. Comparing with bank interest rate is seems it is relavant. Because it is return on investment not return on sales. So be clear in comparing profit percentage and ROI percentage.
Four method of ROI calculation
- Net present value,
- Internal rate of return, and
- Profitability index
It is defined in terms of time – months / years. So your return of investment will cover within shorter period means it is better.
Net present value:
Both cash inflows and outflows by the project will be valued at present by discounting method. If cash is in possitive and higher then project seems better.
IRR – Internal Rate of return
The cashflows of present and future ie., expenditures are valued at present by using formulaes. If it is higher then the capex is better to select.
The profitability index (PI), also knows as profit investment ratio (PIR) and value investment ratio (VIR) is the ratio of payoff to investment of a proposed project. It is an indication of the costs and benefits of investing in a particular capital project by a business firm. It is a cost/benefit ratio used in capital budgeting financial analysis.
Now, How you are managing your company projects. Give your thoughts here.
Let’s Examine Using Historical Reference.Over the past years, companies have typically spent money for capital expenditures for a number of reasons, such as, the need to replace older existing equipment or acquire new equipment to grow their business, or complete some major repairs to a building. Later, when efficiency improvement became more popular (and such equipment became available), companies started to replace current equipment with more efficient ones in order to gain efficiency by reducing man power (by automating processes), waste, and energy.
Questions from the approvers start to fuse from all directions:
- How much of this project is saving energy and how much is simply to make us look greener?
- I do not understand this project, how do we measure the immediate benefits for the company?
- Do we do use standard methods such as Payback, NPV, IRR?
- Can we get grants for the project?
- How many grants are we sure to get and how much are based on your internal guesstimates?
- Is this is for safety reasons? Why was it safe last year and all of a sudden, it is now not safe? What changed?
- Are we are replacing because of legislation? Which legislation is it? We just changed the equipment last year; can we continue as we are doing now?
After approval of capex
- Monitor the capex made during the period
- Confirm the asset is installed or working
- Capitalise the asset in books
- Get installation certificate from the owner of the project.
To monitor the budget, ERP like SAP having options and separate modules. Asset Accounting in SAP fico is more useful. It gives separate internal order number for each project. Once project budget completed they cant book beyond the expenses already made. Finance professional can monitor the expenditures in single sheet.
Documentation of installation and completion of projects also become essential for book closure, depreciation run, statutory audit.
Hope it is useful for you. Please give your thoughts.