Capital Expenditure

CORE CONSIDERATIONS IN

Note For Entrepreneurs

The first is related to capital expenditure, which falls on the P&L after EBITDA in the form of depreciation and amortization costs. Once you remove depreciation and amortization from EBITDA, you arrive at EBIT, which is a better measure of profitability.

While it is extremely popular to use EBITDA as a measure of operational performance, it is more of a superficial metric. We believe that EBIT should be used to get a realistic picture of how the assets are performing.

Every Capex builds an asset that also comes with maintenance costs, time involved in maintenance (assessment of uptime vs downtime), parts replacement costs and eventual replacement at the end of its life. The overall value generation by the asset over the period of its life must be positive in order for the investment to make sense and adding to the going concern of the business.

For instance, consider an example of a coffee house and specifically a coffee machine as an asset. When one buys a coffee machine, they. have to an upfront payment to acquire (purchase) the machine that is in principle a Capital Expenditure. The machine serves as a central production machine that produces espresso, using which all the beverages are prepared. For every cup of coffee sold, and entrepreneur has to set a price that generates enough margins per cup sold so as to cover all the costs related to the cafe business and also cover the overall cost of the coffee machine over a long period of time. The overall volume of the number of cups sold every month multiplied by price per cup gives the total revenue made for a month and total margins made. After covering all the operational costs of the cafe, ideally there should be some profit left to cover the not so obvious costs of the cafe. These costs come in the form of actual cost of machine distributed a long period of time, repair and maintenance related costs that may need to be incurred from time to time and if by any chance the machine completely breaks down you may eventually need to buy a new machine.

If we look at the P&L, the EBITDA should be high enough to be able to cover all the costs in long run. You must accumulate some absolute amount every month so that these costs are covered in the future.

We have seen a lot of new age entrepreneurs ignoring these facts and burning money year over years due to low margin sales.

Thus, we recommend calculating these costs on each asset capex for all the factors related to that asset. These cost factors are usually common across the board.

Key Ideas

Capex builds assets.
The upfront cost of any capital expenditure does not get incorporated in the P&L at a go. It gets spread, usually uniformly, in the form of regular figures, maybe on a monthly basis or on an annual basis. In the case of intangible assets, such as software purchase or patent, the spreading of cost over a time period is called amortization. In the case of tangible assets, such as machinery, a building, or any other hard asset, it is termed as depreciation.
Assets, such as a machine tool, have a finite life and a production capability, so over the life of the machine tool, it should be able to produce goods in a certain volume and should be sold at a certain price so that the overall margins would cover the cost of replacement defects in the next cycle.
Total cost is the cost of purchase plus the cost of maintenance and repairs minus the reselling cost.

Note For Investors

As an investor, your returns usually depend on the value that the business creates. An investor must look at the quality of assets acquired by the company they are investing in and also try to understand how the entrepreneurs are able to use the assets efficiently. The efficiency of usage of the asset determines at what rate the entrepreneurs are generating value in the company, because if the total asset capacity is not utilized The overall value generation from production and selling of goods and services is going to be low because time is always a constraint.

At the same time, irrespective of the efficiency, the asset is going to have a finite life. Within that finite life, it has to be able to generate great value that helps pay all the other bills through the margins that are created from selling the products.