THE BUSINESS OWNER’S GUIDE TO THE 2 TYPES OF CAPEX

CapEx doesn’t hit your books every month, so it’s easy to ignore until something breaks. A truck, a laptop, or a machine you can’t operate without.

Early in my CFO career, I worked in a low-capex business and just hit my groove… then multiple trucks broke down at once. No plan. No budget. Just stress. I’d failed to plan and felt like a complete newb.

I wasn’t alone. Most businesses don’t treat CapEx as a system. It’s ad hoc. Emotional. Reactionary.

But CapEx is capital allocation and a use of your hard-earned strategic cash. If you make those decisions on a whim, you’ll find yourself tight on cash, again and again.

So this week, let’s fix that.

But first, we have to start by defining it.

DEFINING CAPEX

Without knowing what a term means, we can’t talk about it, so let’s start there. And to really understand CapEx, we need to know the other side of the coin too: OpEx.

OpEx (Operating Expenses) = everyday expenses that keep the lights on (salaries, rent, software, fuel)

CapEx (Capital Expenditures) = investments in assets that last longer than one year (land, vehicles, equipment, major software)

Some examples:

The IRS draws a soft line at $2,500 for CapEx, which is a decent threshold. If it costs more than that and lasts more than a year, it’s probably CapEx. If it’s under $2,500 or gets used up quickly, it’s likely OpEx.

CapEx gets recorded on your Balance Sheet, then depreciated over the estimated life of the asset. Depreciated is just a fancy way to say “we’re going to spread out this cost based on the expected live, or usage.”

If recorded all at once on the Income Statement, it could skew profits, as these expenses are typically bigger. So by spreading it out, we get a real annual “cost” of that expense.

But, unless financed, the cash goes out today. So this is one of the reasons I’ve harped on knowing the difference profit and cash.

TWO KINDS OF CAPEX (AND WHY IT MATTERS)

Not all CapEx is created equal. And knowing the type of CapEx helps you make better choices.

Let’s use an example to explore this.

Say I’m a service business that requires $100,000 of equipment to be purchased every 4 years. If that equipment breaks, revenue halts. Replacing it = Maintenance CapEx.

But if you’re buying $100,000 of new or upgraded equipment to increase revenue or capacity? That’s Growth CapEx.

They serve different purposes and demand different decision-making.

MAINTENANCE CAPEX

This “keep-the-engine-running” spending shouldn’t surprise us, but it often does. To avoid this we need to:

1. Inventory your assets
   • What do we own?
   • When was it purchased?
   • What’s the expected useful life?
2. Assess its condition
   • Organize by asset type
   • Rate them A-F based on condition
3. Build a replacement schedule
   • Estimated replacement year
   • Estimated replacement cost
   • Understand maintenance cost & risk

The big unknown is understanding when equipment needs to be replaced. Sometimes this is simple, but often it’s not.

The best way to approach this is to create soft rules that guide replacement, but ultimately use your eyes as the final decider.

There are many ways you can track and create rules, so we’ll address some below:

Percent of replacement value rule: Divide repair cost by estimated replacement cost (ERV). If the repair costs more than X% of the ERV, buy the new equipment instead.

A common number is 2%, but it can vary widely by industry. Some could even be up to 50%. So, get a better understanding of norms in your industry and create a rule for yourself.

Percentage of revenue: Go back through your history and determine how much repair cost is a percentage of revenue. Over time, you want to see both maintenance and CapEx going down as a percentage of revenue, especially when growing. When. you see maintenance tick up in true dollars and as a percentage of revenue, it could be a sign your equipment is wearing out.

Depreciation rule: If the cost to repair your equipment is greater than the depreciation each year, it might be time to replace it. It’s simple, but could be too simple, as one big repair could mean no more in the near future, but trip this wire.

Remaining life cost of maintenance: Manufacturers will typically have a maintenance cost schedule, which can be helpful in understanding what to expect. you can use this, as well as gained knowledge through use, to determine where in the schedule you want to replace.

An expensive part typically break down at 10,000 hours? Replace your equipment before then to avoid the big maintenance expense.

Downtime cost: Employee downtime can mean expense without output, so often you’ll optimize replacement around reducing downtime from maintenance.

If downtime cost is too high, it can make sense to have backup equipment to ensure there isn’t any. For example, for an employee charging $150 per hour, it only takes 15 hours to cost $2,250 in billing, which is likely more than a new computer. When many users have the same computer, it makes sense to have backups.

While a simplistic example that doesn’t account for high-cost manufacturing situations, you get the idea.

These aren’t perfect, but they give you guidelines instead of gut calls.

GROWTH CAPEX

Too often businesses just evaluate the choices that come to them instead of proactively coming up with a plan. With Growth CapEx, we want to think in terms of your strategic plans and what types of things you might need.

Think of this as “fuel-the-fire” spending.

To appropriately approach this, we need to be strategic. We want to:

1. Identify and prioritize growth potential
2. Evaluate the possibilities against your goals
3. Calculate the cost (Payback, ROI, etc)
4. Do risk + scenario planning

Your list should be driven by your strategic or annual plans. If you don’t have those, sit down and come up with a list.

Then, to evaluate the possibilities, you have to rank them. Below are a few ways to measure the opportunity.

1. Payback period: This is the time it takes for an investment to generate enough cash to cover the cost.
2. Net Present Value (NPV): This measures whether earnings from an investment exceed cost.
3. Internal Rate of Return (IRR): This is the estimated return of an investment over a period of time.
4. Return on Investment (ROI): This is the ratio between net profit and cost of investment.
5. Cash Flow Impact: how cash flows change based on the investment.

To go deeper on these, click here to download an infographic.

Once you’ve done your evaluation, consider doing some scenario planning with the different Growth CapEx options so you can see them side by side, as well as assess the risks.

BUDGETING FOR CAPEX

By doing the planning I’ve mentioned with both Growth and Maintenance CapEx, you’ve done the 90% required to create a budget.

But in budgeting, we want to make sure we understand:

1. How much of each we can sustain
2. How each thing is going to be funded (cash, reserve, or debt)

If you’re funding with cash flow, those cash flows have to be there before the purchase can happen. But, if funding with debt, you have a little more flexibility.

Don’t just set the plan and forget it. Evaluate it in light of current conditions before you make your buys.

By having an annual budget cycle, you can “punt” big CapEx decisions into this annual planning cycle and get yourself out of the one-by-one requests that your team brings.

It’s not that we don’t make these CapEx purchases, just that we want to ensure they’re evaluated in context of the bigger picture and goals of the business.

WRAPPING UP & NEXT STEPS

CapEx is one of the clearest expressions of your capital allocation philosophy we want to adopt. If you want to grow, preserve margin, and reward yourself as the owner, you need to budget and prioritize CapEx like a portfolio manager, not a firefighter.

That means:

1. Planning ahead (replacement schedules)
2. Creating a request process (especially as your team grows)
3. Comparing options (maintenance vs. upgrade vs. new)
4. Assessing tradeoffs (cash vs. financing vs. delaying)

I’d encourage you to spend a little bit of time this week to:

1. List your biggest maintenance CapEx needs
2. Identify your top growth CapEx ideas
3. Sketch a rough plan

You don’t need done, just a start.

We’ll see you again next week.

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