Understanding Capex vs. Depreciation: The Basics
Capex and depreciation are two types of accounting items that both impact a company’s overall financial health. Understanding the differences between Capex and depreciation is critical for properly managing business finances. This guide provides an overview of the basics of Capex vs. Depreciation.
What is Capex?
Capital Expenditure (Capex) is money invested in a business to acquire, upgrade, or maintain assets such as buildings, machinery, land, vehicles, and equipment. Capex creates long-term value for the business and incurs expenses that may be spread over several years. By investing in capital expenditures, businesses can generate returns over the expected life of the asset.
What is Depreciation?
Depreciation is a non-cash expense that recognizes the cost of an asset over its useful life. Depreciation spreads the cost of an asset by allocating it over several years based on its expected lifespan. In other words, depreciation reflects the gradual reduction in the value of an asset as it gets older, wears out, and becomes obsolete. This process allows businesses to reduce taxable income and defer income taxes until the asset is sold or retired from service.
How Do Capex and Depreciation Differ?
While depreciation and Capex both concern expenses related to the purchase of assets, they are two distinct concepts. Capex is a shorthand term for capital expenditures, which refers to money spent on acquiring or maintaining physical assets such as equipment, buildings, or technology. Depreciation is an accounting technique used to spread out the cost of an asset over its useful life. Capex involves actual cash outlay for purchasing an asset, whereas depreciation does not involve any cash flow.
How Does one Calculate Depreciation?
Depreciation may be calculated in several different ways. One of the most common is straight-line depreciation, which divides the original cost of an asset by its estimated useful life to arrive at a base depreciation amount. The asset’s salvage value is then deducted from the total cost to determine the final amount of the depreciable cost. Other methods, such as accelerated or double declining balance depreciation, may also be used in certain circumstances.
What Factors Affect Capex and Depreciation?
Both Capex and depreciation can be affected by inflation, exchange rates, legal restrictions, and market conditions. For example, increasing prices due to inflation can make a fixed asset more expensive over time and require a higher level of Capex or more aggressive depreciation to reduce the associated costs. Additionally, changes in legal regulations or market conditions can have an impact on both Capex and depreciation decisions.