Part 1, Lesson 8
The purchase of fixed, tangible assets (last longer than 12 months) is referred to as capital expenditures (“capex”). These fixed assets represent long-term assets of the company and are deployed in the operation of the business and generation of revenue. All companies will have ongoing capex needs as the purchase of new fixed assets are necessary for the growth of the company.
Capex items may include buildings, building improvements, furniture, appliances, cars, airplanes, and IT equipment to name a few categories. As an example, for a company like Verizon, its yearly capex is deployed in improvements to its fiber optic infrastructure, buildout of new fiber infrastructure, server and data center equipment, wireless towers and associated equipment, and real estate investments.
When a company purchases capex, the cost of the capex goes into the Property Plant & Equipment line item (also frequently referred to as Furniture Fixtures & Equipment), but a capex item is not expensed upfront in the income statement. Since the useful life of a capital expenditure is typically long-term in nature, we will “expense” the cost of the capex item by depreciating it over its useful life (refer to Part 1, Lesson 7 for more detail on depreciation).
How do companies finance the purchase of fixed assets?
Companies may choose to purchase fixed assets through the use of cash, use of debt, or through a lease. The first two are easy to understand. If a new car costs $32,000, a company may purchase this through cash on hand or by borrowing the $32,000 as a loan.
Fixed asset purchases may also be financed by entering into a lease of the asset in question. This can be done through either an operating lease or capital lease. But one caveat – if a fixed asset purchase is financed through a lease, it is accounted for differently than a fixed asset purchased through cash or debt (which flows through the cash flow statement as capex).
Operating vs. Capital Leases
Aside from the use of cash or debt, fixed assets can also be financed through an operating lease or capital lease, but whether something falls into the operating lease bucket or capital lease bucket depends on the terms of the actual lease.
A lease is considered a capital lease if one of the following conditions are met: 1) ownership of the asset / item pass to the lessee at the end of the lease term, 2) lessee has an option to purchase the asset, 3) the term of the lease is greater than 75% of the useful life of the asset, 4) the present value of the lease payments is greater than 90% of the value of the asset.
If the above conditions are not met, the lease is considered an operating lease. An operating lease is easy to understand. Instead of purchasing a car for $32,000, let’s assume that the company leases it from the dealer for $500 per month for 3 years. This $500 monthly lease payment is simply accounted for as a lease expense in the income statement. It does not fall into the capex category in the cash flow statement.
On the other hand, a capital lease of an asset is treated similarly as owning an asset outright (even though legal ownership resides with the lessor). The capital lessee is seen as having the same/similar benefits and risks as an actual owner of the asset, so capital leases are eligible for depreciation and are shown on the balance sheet as an asset.
Below is how a company will account for a capital lease:
- Record the present value of all capital lease payments by increasing a lease liability on the balance sheet and simultaneously increasing the Property Plant & Equipment line item.
- Each lease payment is split into an implied interest payment and principal payment. For example, if the monthly capital lease amount is $500, this may be split into $200 of interest expense and $300 of principal payment.
- The portion of the lease payment that is interest expense and the straight-line depreciation expense of the car will flow through the income statement.
- The portion of the lease payment that is principal will flow through the cash flow statement under the Cash Flow from Financing Activities section.
Let’s run through how the purchase (or lease) of a $32,000 car can differ depending on the method of financing:
- Purchase the car outright with $32,000 cash or $32,000 loan
- On the balance sheet, increase the car asset by $32,000 and decrease cash by $32,000 (or increase a loan payable by $32,000).
- On the income statement, deduct the depreciation expense associated with the car.
- On the cash flow statement, $32,000 of capital expenditures will show in the Cash Flow from Investing Activities
- Enter into an operating lease for the car
- On the balance sheet, no adjustment is made.
- On the income statement, deduct the operating lease payments as an expense as they occur.
- On the cash flow statement, the operating lease payment implicitly flows through the Cash Flow from Operating Activities section (since it has already been deducted in arriving at Net Income in the income statement).
- Enter into a capital lease for the car
- On the balance sheet, increase the car asset by the present value of the capital lease payments and increase a lease liability account by the present value of the capital lease payments.
- On the income statement, deduct the depreciation expense associated with the car and the portion of the lease payment that is considered interest.
- On the cash flow statement, the portion of the lease payment that is considered principal will be deducted from the Cash Flow from Financing Activities
So why is any of this important? It should be clear that depending on the financing arrangement, a company can enjoy the benefits of owning/operating a car but present the financing of the car in different ways. For example, purchasing a car through a loan increases the overall financial leverage of the company, whereas leasing a car through an operating lease keeps this liability off the balance sheet. A company that leases the car through a capital lease has the ability to move a large portion of the car expenditure out of capex and into Cash Flow from Financing Activities. This can have the net effect of making capex appear lower than it truly is.
None of these activities should necessarily be viewed as something inherently good or bad or right or wrong. There are numerous reasons for why a company may choose one form of financing over another, but as an investor, it is important to understand how these financing arrangements affect the presentation of the financial statements.
Let’s take a look at an example below.
Twitter’s Cash Flow Statement
In Twitter’s cash flow statement, we have highlighted in red two different line items, “Purchases of property and equipment” and “Payments of capital lease obligations.”
Purchases of property and equipment (which may be labeled slightly differently depending on the company preparing the statement) is the capex line item. However, if we only looked at purchases of property and equipment when determining capex needs, we would severely underestimate the amount of capex required by Twitter.
This is because Twitter has consistently spent $100 million in capital lease principal payments every year. Since these capital lease payments are going towards fixed assets, these amounts should be included when evaluating the cash flow generation of the business.
In other words, if we ignore the source of financing for fixed asset purchases, the true capex requirement in 2017 was not $161 million, but was really $161 million capex + $103mm capital lease payments = $264 million.