The deception of capital expenditure and working capital in business valuation
The demand for business valuations continues to grow with the improvement of the economy and the rise of baby boomer retirement. Performing high-quality valuations has become more important than ever before to meet client expectations and compete in the industry. To reach the true value of a company, one must have a comprehensive understanding of each factor that goes into the calculation.
This article includes an overview of capital expenditure (CapEx) and operating expenditure (OpEx) as well as considerations for how best to utilize these numbers in valuation engagements.
A brief overview of capital expenditure and operating expenditure
A company uses certain funds, most commonly known as CapEx, to
acquire or upgrade physical assets. The cost of the capital items is first recorded on the company’s balance sheet as assets. Then, it appears as a depreciation expense on the income statement for each year of the asset’s depreciable life. Some examples of capital expenditures are building upgrades, software purchases and new office equipment. Any costs incurred in bringing the asset into its present location and condition are also considered, so even product delivery, installation and replacement, if necessary, are categorized as capital expense. Companies and organizations normally designate specific criteria that must be met for an acquisition to qualify as “capital,” such as a minimum useful life (usually one year or more) and a minimum purchase price.
Someone fresh to finance might confuse CapEx for OpEx. Operating expenses are shorter-term funds used to meet the day-to-day costs of running a business, such as utility costs or asset repair. Although it can be difficult to determine the difference, a simple way
to distinguish the two is as follows. If the funds do not contribute value to the property and equipment of a business, then they should be classified an operating expense.
Capital expenditure versus capital maintenance expenditure
According to Equicapita, the effect of capital expenditures on a company’s valuation is dependent on the category of CapEx being spent by the company. CapEx can be used for either a company’s maintenance or growth purposes. Capital maintenance expenditures (CapManEx) represent the replacement, renewal or
restoration of assets. A company that uses most of its annual CapEx
to maintain production usually has a lower valuation than a company that does not have high annual maintenance costs.
Another important number in business valuation: Working capital
Working capital is commonly known as the difference between current assets – items that are cash or can quickly be converted to cash – and current liabilities, meaning debt obligations due within a year. It refers to the cash a business needs for its daily operations and is a common measure of a company’s liquidity, efficiency and overall health. If a business requires large amounts of working capital, a valuation of that business is typically lower.
An alternative approach to working capital and CapEx
Valuation expert and professor of finance at NYU’s Stern
School of Business, Aswath Damodaran, offers a new look at CapEx and working capital. Accounting standards in the U.S. require the treatment of research and development (R&D) as operating expenses, but Damodaran suggests that they should be considered as capital expenditures. He argues that R&D is more long-term than investments in a company’s physical space and equipment.
Additionally, Damodaran explains that working capital should
be defined not as the difference between current assets and current liabilities, but as the difference between non-cash current assets and non-debt current liabilities. Also, he opts not to factor cash into working capital because it is considered to be an asset that does not lose value over time, unlike other assets such as vehicles and machinery.
Whether you take Damodaran’s advice or not, your assessment of a company’s value must be well documented and carefully approached both to ensure accuracy and to create growth opportunity for your practice. Following a consistent process can reduce errors and create a repeatable system that can be used for other valuation clients.
For research-intensive businesses, considering R&D as a capital expense, for example, can have profound effects on the financial snapshot of a business. It is important for valuation experts to know how each aspect of a company’s finances – including the method of calculation – can impact the final valuation.
For more content from Aswath Damodaran, visit his website.
Learn about changes in business valuation by downloading the whitepaper: Changes in the Business Valuation Industry: Opportunities and Pitfalls.
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