Navigate the complexity of Capex and use our free template to make better decisions
February 23, 2022 2 min read
The complexity of capital expenditure (Capex) plans is a challenge to Finance leaders charged with directing a company’s strategy. Capex plans are crafted for a 5- to 10-year period and underpin your company’s long-term growth trajectory. If you plan on increasing sales revenue, you need to plan Capex to support this growth.
Though it may seem simple, planning capital expenditures can become complicated quickly. Economic disruptions like COVID-19 can scrap the best-laid plans overnight.
For example, in retail industries, the pandemic accelerated demand for companies to directly interface with customers, spurring the direct-to-consumer (D2C) business model.
Do situations like this necessitate additional investment or demand Capex austerity? These are complex questions that Finance and executive teams need to grapple with. Making fleet-footed decisions confidently can only be done by forecasting Capex accurately.
As we mentioned previously, the pandemic brought about a change in e-commerce with the D2C business model. Today, founders face few barriers to entry in starting an e-commerce business. Many companies are ready to support a company’s packaging, shipping, and distribution needs. But doing the same thing as the competition doesn’t confer a distribution advantage in the long run, so it’s worth considering changing tack.
An alternative strategy would be to bring these operational capabilities in-house and plan for upfront capital requirements while also keeping an eye on long-term financial effects. But a big commitment is a risk of its own. Business owners also want their plans to incorporate the flexibility to change this strategy by realizing an asset’s value on its balance sheet and being able to liquidate it. Flexibility allows them to react with a new strategy should another significant economic shock come along.
Let’s dive deeper into an e-commerce example case using OnPlan’s Capital expenditure forecast template, which we’ve designed to help companies make strategic capital allocation decisions.
To see how Capex forecasting works in action, consider a fictional company, BrickAndCyber, operating in the Food and Beverage (F&B) sector as our capital expenditure forecast example.
We’ll use BrickAndCyber to walk you step-by-step through how to think about your Capex plan using OnPlan’s Capex forecast template to support the Capex budgeting process.
BrickAndCyber is a food startup that, after having gone the brick-and-mortar route, has gained more traction by distributing through national grocery chains. They’re considering a D2C strategy and weighing the upfront capital required to execute it. They also need to decide when to purchase each asset and the best way to absorb the costs of these assets over time.
Ultimately, the BrickAndCyber CEO wants to know whether investing in an in-house fulfillment center will support their future revenue growth.
For the purposes of this example, we’re considering the costs only.
Let’s first examine the base case scenario, where BrickAndCyber will rely on third-party fulfillment and not require capital expenditure. The company outsources its fulfillment to third parties, who manage all aspects of the process, including holding inventory, packaging items, and shipping orders.
In the working case (Case 1), BrickAndCyber invests in an in-house fulfillment center, which will incur a considerable Capex outlay. BrickAndCyber undertakes Capex investments to support its transition into a D2C business model, including the purchase of a warehouse, warehouse management software (WMS), warehouse machinery items, like conveyors and forklifts, and an EV fleet.
Let’s use OnPlan’s Capex template to analyze BrickAndCyber’s costs in undertaking the Case 1 option. We’ll begin with the assets required and the cost involved before going into the nuances of how this affects the company’s discretionary asset expenditure.
In Capex forecasting and budgeting, the actual purchase value of the asset is only one consideration in the process. In fact, there are various elements that interact with the asset. When taken from the point of view of your company’s accounts, those interactions could change your appetite to proceed with a given asset purchase.
Look at the chart above, where these various asset-influencing elements are listed in the columns. Keep in mind, they cannot be considered individually because of the interdependence between them.
For example, whether you can write off an asset is dependent on whether it will be used in your business’s core operations. Your tax consultant can guide you on the correct capitalization percentage. From a timing perspective, the asset may be determined to have a useful life of seven years, but this figure is a moving target determined by the depreciation method chosen.
BrickAndCyber has prioritized the order in which the Capex purchases will take place. The first asset—the warehouse—is purchased in 2022. The lion’s share of the remaining investments are undertaken in 2023. From here, it’s up to management, and, in certain cases, IRS rules and regulations, to determine the method by which the company will absorb these assets on its balance sheet.
The difficulty for an organization’s Finance leader is that the same depreciation treatment needs to be applied to all assets that fall under an umbrella asset class.
For example, the purchase of a new office would, along with the warehouse, fall under the “Buildings” asset class. OnPlan’s Capex template cuts out this complexity by applying the same depreciation method that has been stipulated for the asset, even if it has a different useful life. This situation commonly arises when a subsidiary of a business applies a longer period to an asset than its parent would.
In determining taxable income, your company’s earnings (EBITDA) are reduced with depreciation charges. After depreciation charges, we arrive at the Earnings Before Tax (EBT) line item on the income statement, which, as the name suggests, will be the amount on which your tax bill is calculated. It’s clear then that depreciation has a considerable bearing on the timing of tax payments, but knowing this, how do you select which depreciation method to choose?
All too often, businesses write off an asset as quickly as possible to reduce their immediate tax burden.
Theoretically, that makes sense. A dollar of tax paid this year decreases your company’s value to a larger extent than a dollar of tax paid next year. However, in practice, shortening your depreciation schedule and accelerating the deductions isn’t always the right approach. The right approach is the one that is appropriate to your business and context.
Let’s return to BrickAndCyber as our forecasting Capex and depreciation example. Below we compare different possible depreciation methods.
An accelerated depreciation schedule is helpful for startups and indeed all businesses in their formative years of operations, which is a timeframe notoriously characterized by cash flow constraints.
By making higher deductions now, companies reduce their current tax bill and reinvest these tax savings back into the company to supplement growth.
However, this approach does not take into consideration the business context. Other factors need to be considered too, and none is more important than revenue. For example, if BrickAndCyber projects that its revenue will increase rapidly from the medium term and onward, it may place the company in a higher tax bracket.
The company then can’t afford to be left without assets to offset its income during this time. The Finance leads will need to evaluate which methods leave them with the highest depreciable amounts in the period where revenues are high and a lower tax bill is needed. This requires them to consider multiple depreciation treatments on various assets simultaneously. It’s an arduous task that calls for a sophisticated model to do the heavy lifting.
For BrickAndCyber, it follows that the company should instead choose a conservative depreciation method that gives them the leeway to offset income in a later period. This can be seen for both existing and planned assets, where the depreciable allowances are, by design, the largest across the 5- to 10-year period.
In a similar way, if you are applying OnPlan’s Capex forecast template to your company, the template serves as a valuable tool to analyze the effects of multiple depreciation treatments across asset classes.
Forecasting capital expenditures is a vital aspect of mid-to-long-term financial planning. A thorough Capex plan can help your company make sound decisions about which assets to invest in and when. It can also inform which depreciation method you choose to help you minimize your EBIT line on your income statement.
Given the complexities of Capex planning, it’s essential to use well-developed FP&A tools that can help you plan your capital expenditures based on the specific context of your business needs.
Working with OnPlan can help you get Capex planning right. Download our Capex planning template today or book a demo to learn more about how OnPlan makes financial planning, forecasting, budgeting, and analysis easier and more efficient.
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