Understanding Capital and Revenue Expenditure
Capital Expenditure
Capital Expenditure
Capital Expenditure is expenditure that results in the acquisition or construction of a fixed asset (land, building, vehicle, furniture, or equipment) or enhancement of an existing fixed asset. To be considered a development, the work undertaken must either:
- Substantially lengthen the useful life of the asset.
- Substantially increase the market value of the asset – if the asset were valued after the works, it would be valued at a higher value than before the works.
- Substantially increase the extent to which the asset can or will be used for the purpose.
Revenue Expenditure
Revenue Expenditure is expenditure incurred for the purpose of the organization’s daily activity, service/trade, or to maintain fixed assets; for example, employee’s pay, travel expenses, and consumables.
Why Businesses Need Finance
Startup Capital
A business might need finance at the start in the form of capital. This is known as startup capital. Startup capital is used for initial investments such as land, building, machinery, employee salaries, etc.
Expansion
A business might need an additional source of finance when it needs to expand. This expansion may include:
- Extension of present facilities, such as purchasing additional machinery and extending capacities.
- Acquisition of another business through a takeover. Usually, a business will have to arrange a huge amount of additional finances for these purposes.
- Entering new markets. It involves huge investments in research and development and aggressive marketing campaigns.
Research and Development
Businesses need finance to develop new products. Multinational businesses usually spend millions of dollars every year on Research and Development purposes.
Running of the Business
Apart from investment at the initial stages, a business needs a constant flow of capital in the form of working capital.
During Trouble Times
A business might need an additional dose of capital or financial help during troubled times, such as a recession, or when the sales of the business fall temporarily due to market conditions.
What is Working Capital?
Working Capital is the cash available to the business for carrying out its day-to-day activities. It might include paying for labor wages, purchasing stock, paying short-term creditors, etc.
The working capital ratio is calculated as: Current Assets / Current Liabilities Positive working capital means that the company is able to pay off its short-term liabilities.
Importance of Working Capital
- If a company’s current assets do not exceed its current liabilities, then it may run into trouble paying back creditors in the short term. The worst-case scenario is bankruptcy.
- A declining working capital ratio over a longer time period could also be a red flag that warrants further analysis. For example, it could be that the company’s sales volumes are decreasing and, as a result, its accounts receivable numbers continue to get smaller and smaller.
- Working capital also gives investors an idea of the company’s underlying operational efficiency. Money that is tied up in inventory or money that customers still owe to the company cannot be used to pay off any of the company’s obligations. So, if a company is not operating in the most efficient manner (slow collection), it will show up as an increase in working capital. This can be seen by comparing the working capital from one period to another; slow collection may signal an underlying problem in the company’s operations.
Working Capital Management
Maintaining a stable working capital position in the business depends on the following factors:
- Cash management
- Inventory management
- Debtors management
- Short-term finances