Making a Financial Decision
Most of the decisions we make about the direction we want to take our business in is often tied to financial resources; and, financial resources are often tied to the business lifecycle. For example, whether you are in start-up or growth mode, or your business is in decline altogether, this factor will impact your business decisions. And, ultimately, without financial resources, you won’t be able to move forward with an investment decision.
When we look at CapEx spending, we see that making such investments is always tied to cash flow. So, how do we know what decision to go with when deciding on a particular portfolio? There are several routes to take. There is something called growth CapEx and maintenance CapEx. These are two options that depend on whether or not you want to expand your business or maintain the investments you already have.
There are ultimately two reasons why a company spends money on capital expenditures. The first is to pull it back into the business, the second – to maintain it. If you’ve determined that you need to make a CapEx investment, you need to decide how to pay for it: is it better to use cash or debt?
Let’s take a look at both in detail so you may understand which to go with it in any given situation. We’ll also explore the most effective way of financing your investments.
Maintenance CapEx is a big part of expenditures. It is the process of keeping existing operations running. Whether it is installing a new boiler or replacing old computers, its purpose isn’t to attract more business or expand it; it is to maintain the status quo. Maintenance CapEx is used to improve or replace assets to maintain operational capacity.
Growth CapEx is intended for business growth. It isn’t the process of maintaining CapEx, for the business to operate in its current state, it is deciding where to invest in the growth of an operation. To highlight the distinction, we can look at the parameters of these two concepts in the context of a retail store.
A retail business owner wants to refurbish his existing store. He wants to lay down new flooring, paint the walls and replace an old fridge. He is engaging in maintenance growth. But, if the retailer wants to expand and acquire a new store, he is increasing his asset base and capacity – he is growing the business.
To understand the difference between maintenance and growth CapEx, look at your company’s depreciation and CapEx numbers. When CapEx exceeds depreciation, it is considered growth CapEx since you are expanding your asset base beyond maintaining it.
Financial CapEx refers to spending internal cash to pay for CapEx – an alternative to debt. Banks will be determining your credit status, and looking at all your sources to have an understanding of how you are using your cash. In many cases CapEx takes a toll on cash flow; the more cash you are spending on CapEx, specifically growth CapEx, the less money is available for debt payments. CapEx that is financed with debt doesn’t reduce your cash flow, but when it is financed with cash at hand, it reduces it.
Internally financed CapEx is part of the fixed charge coverage ratio (FCCR) that determines a company’s ability to repay its debt. Banks often ask for an estimate of internally financed CapEx so the number won’t be included in any financial statement even though it’s necessary to calculate the company’s ability to repay debt.
Why these distinctions matter
CapEx has a direct impact on a company’s cash flow. If maintenance CapEx is high, your free cash flow will be low. As free cash flow is the cash that’s available for debt repayment after operating expenses and CapEx commitments have been paid, you need to ensure that you are utilizing your finances most efficiently.
If maintenance CapEx in the future is expected to be high free cash flow, you will be spending cash, and your financial resources will turn negative. In this case, you will need to find new sources to fund the gap; and, that would be in the form of debt if you don’t have enough free cash flow.
Investments are always expensive. That is why a potential acquirer of a company will pay attention to the maintenance CapEx when looking at whether or not to acquire and increase growth.
If you have CapEx, it’s essential to track how much of it you spend to grow versus maintaining your business, and how much was financed with cash instead of debt. If you are preparing to sell your business, these distinctions matter. The decision to expand or maintain will impact your future investments.
The difference between these elements will help you assess the free cash flows available to make an acquisition, or whether or not to use debt to finance the maintenance of your business.