Community Question - Understanding Capital Expenditures

Explaining capital expenditures, and how to book them     

         

A common theme I have been seeing is a request to explain how to book “capital expenditures” – both by business owners and bankers. But before we dive too far in, let’s answer the big question. “What are capital expenditures?"

By definition, capital expenditure is the money your business spends on fixed (large) assets – with fixed assets being anything from land, properties, equipment, vehicles, and so on. But from my experience, a lot of business owners run into trouble when they have to decide which equipment is capital expenditure versus an everyday expense. 

The confusion comes from having to scale the rule down to meet your business size. If we look at the rule for capital expenditure – it appears straight forward and pretty clean cut (if you're a multi-million dollar company). However, look deeper and it’s apparent that it wasn’t written for small to mid-size business owners. The everyday business owner isn’t going to be in a position to buy a $1 mil building or a $70,000 piece of machinery. Those kinds of acquisitions are pretty black-and-white when it comes applying capital expenditure. But what do these grey areas look like for most small business owners? 

• A dentist buys an x-ray machine during a liquidation sale for $500.
• A freight company buys five used trucks for $2,000 apiece.
• A carpenter buys $6,000 in small tools/equipment
• A manufacturer rebuilds a motor for $6,000 so it can operate a machine worth $12,000

Right off the bat, we can see that these meet the qualifications for capital expenditures. It is the purchase of land, properties, and equipment. But how should you book these expenditures so your financials are accurate?

 “A dentist buys an x-ray machine during a liquidation sale for $500.”  

This meets the capital expenditure definition as it is a piece of equipment. However, it is a very small dollar amount and one has to ask, “Is it worth holding onto the balance sheet to be depreciated?” The standard accounting answer to this is “probably not worth the extra effort to depreciate over the next 10 years."

So this is an example that, although it is a capital expenditure by definition – it can easily be expensed on your Profit & Loss without too much of a second thought.

“A freight company buys five used trucks for $2,000 apiece.”

On the surface, this appears to be a situation that could also be expensed on the Profit & Loss just like the dentist example. It is only $2,000 where a new truck would normally run around $25,000. But there is a catch on this one – the company bought five trucks. This brings the total purchase to $10,000.

In this scenario, the truck acquisition should definitely go onto the Balance Sheet under Fixed Assets. The reason being, those trucks have a useful life of several years and booking them onto your Profit & Loss would not only make a month look bad – but it would also give an understated view of your financials. Which could be bad if you are going before a bank for lending purposes.

“A carpenter buys $6,000 in small tools/equipment.”

This scenario is a bit trickier, as it does not tell us what makes up the “small tools/equipment”.  This is where having an accountant is handy – if these happen to be small power tools; then they definitely should be on your balance sheet as those also have a useful life.

However, if these happened to be screwdrivers, plugs, hammers, and such – then it is debatable. The question then boils down to, how closely do we want to track these particular items? The last possible way for this to turn out is if these tools/equipment are perishable or be depleted.

If the answer is “yes” then they are definitely not fixed assets. But this is a situation where an accountant or Outsource CFO would be ideal. As it is up to them to make that judgment call and keep your financials consistent with the decision.

(To those accounting savvy people out there – if it is perishable/becomes depleted; it could be considered inventory. So, A+ if you knew that.)

“A manufacturer rebuilds a motor for $6,000 so it can operate a machine worth $12,000.”

This one is definitely a capital expenditure but not because it is a piece of equipment – but, more due to accounting regulation. When it comes to fixed assets and depreciation, the IRS recognizes that if you spend enough money on a piece of equipment; it can be considered a new capital expenditure.

So in this situation, you have already bought the machine and booked it on your balance sheet as a fixed asset. During the time that you have owned this machine, the motor broke and you had to spend an additional $6,000 to fix the motor.

That $6,000 makes the motor a new piece of equipment because the IRS states that any repairs done to a fixed asset that exceeds 50% of its current worth, is considered a new capital expenditure. Thus, in this case, you should add $6,000 to your fixed assets on your balance sheet.

Lastly, while few business owners find themselves in this situation – it definitely pays to have an accountant who can interpret the regulations to your benefit. Otherwise, the $6,000 can easily find its way onto your Profit & Loss and ruin an otherwise good month or even hamper your borrowing ability.

To conclude this, capital expenditure is definitely something all business owners have to contend with at some point in their career – and it pays to have an accountant help you through these moments. An incorrect booking of capital expenditure can lead to inaccurate financials, however, it can also lead to an inability to borrow from a bank which can make all the difference for a small business.

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Community Question: Understanding Cost

Many business owners (and even some accountants) struggle with the concept of cost – and rightly so. A simple Google search on ‘cost’ yields thousands of results, and all of them growing increasingly technical.

My intention with this blog is to provide clarity on these matters, with a focus on some of the most common questions I have received from the community regarding costing.

What does it mean when an accountant refers to “Cost”?

When an accountant refers to “cost” or “cost of goods sold” – they are referring to the direct-variable cost of providing goods and services. Now, the keyword to this is direct and variable.

For example:

Suppose you’ve manufactured a door - the wood materials, the labor, and the machinery used are all directly related because they are used in the process of manufacturing the door. Furthermore, these costs are considered variable because you could do it faster or slower depending upon your operation.

More stable (fixed) costs - rent, utilities, and insurance - typically don’t fluctuate and you incur these costs regardless of if you are making a product or providing a service. Since they are not variable, they are not considered a cost. That being said, keep in mind this is just one example and rent/utilities can easily be considered a cost in a service industry.

Moving forward, let me break it down even more so it’s easier to understand. When you are confronted with determining what to consider cost versus overhead – apply this simple rule:

If you are willing to calculate it and it is relevant to your industry - it is a cost

Why do accountants make a distinction between my expenses? Aren’t all my expenses considered the cost of doing business?

Yes, all of your expenses (hopefully) are for the sake of your business. However, a distinction between “costs” and “expenses/overhead” has to be made for the sake of managerial purposes. Not only is it easier to identify areas that could use improvements – it also allows you to compare the financial side of your business against your competitors and see how you stack up.

The other reason why this distinction is needed is because cost can be managed (note that I use the word managed, not cut – read further to know why). This management process can be done by finding better suppliers, improving processes, better technology, automation, and so on.

Suffice to say, a distinction has to be made in order to identify areas that can benefit from better management. Keep in mind, these areas will vary from industry to industry, and is almost solely dependent upon your willingness to track certain expenses separately.

How do I determine my cost?

The easiest way to determine what items to consider as costs is to use established industry standards.  Keep in mind, those are more guidelines than actual standards.

In my opinion, the best way to determine your cost is to ask yourself - “What does it take for me to provide this particular goods/service?”

It’s tempting to lump everything into this question, but think of it objectively: you want to provide a good/service – what are the additional expenses associated with it?

That, would be your cost.

Why is understanding my cost important?

Cost is by far, the most underappreciated and important subject any business owner needs to master. By understanding your cost, you can determine your pricing, which, in turn determines your competitiveness in the industry and ultimately – the value you provide your customers.

It is also important to understand cost because it is an ever-changing picture. What was cost last year, could go up or down this year. So, it is important to stay on top of your costs and to always have a good handle on any changes in the industry you’re in.

The last reason to understand cost is because many business owners forget that cost is the cornerstone to profit margin. If your costs are not revisited on a regular basis and changes to pricing are not done regularly – you could end up in a situation where you compete yourself out of business.

What do you mean when you say “Competing yourself out of business”? That seems like a paradox.

When I refer to a company as competing itself out of business, I am referring to a very gradual and seemingly innocent process that, could and will often take years to occur. It is also absolutely irreversible if caught too late.

Competing yourself out of business means, to have a lot of customers, orders, and demands, but not the cash flow to reflect your success.

Now, how is that even possible? Simple, it happens all the time and in most cases, companies don’t even realize it.

For example:

Suppose a restaurant creates a menu price when it opens, and for three years its popularity soars, attracting more customers. This is a great situation to be in – but say they forget to look at their food costs, or they never revise their menu prices… this leads to a lower profit margin and less cash flow. The ultimate predicament created then, is that the popularity of the restaurant is based solely on them never raising their prices – which means, when this mistake is caught and corrected, the popularity of the restaurant will likely suffer with it.

On a manufacturing/retail side, it could be that the cost of labor has increased over the years. This increase in labor has a direct impact on the profit margin of the products – which, if left unevaluated, would ultimately reduce the cash flow of the company (on every item/product that you sell).

This reduction in cash flow can lead to a number of problems – some of the worst being lack of innovations, inability to replace inefficient machinery, lower employee morale, and lack of quality control.

However, during this period, production would be skyrocketing because unchanged prices would make the company’s product the lowest priced in the industry. This deceptive illusion is difficult to catch without a trained eye, but can be easily avoided with proper cost management and tracking.

In conclusion, cost is a difficult subject to comprehend because it changes from industry to industry. That is why it is always recommended to hire an expert, like Tran Nguyen, who can work directly with you and your business to analyze and manage your cost.

Thank you for reading, and as always, your questions are appreciated.
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Community Questions: Understanding Cash Flow

Many business owners struggle when it comes to cash flow management – and rightly so. The concept is a hard one to understand and some accountants even struggle with comprehending the concept – so you’re not alone.

In this blog, I will address several questions submitted to me by the community in regards to their business cash flow.

Why does my net income not match my cash?

In most instances, cash flow will never equal your net income. Even on “cash method” there will always be some delay between the information recorded and what your bank is showing. But if you are on the “accrual method” your net income will never equal your cash.

The recording method for accrual accounting dictates that you recognize your sales and expenses the instant you incur them; not when the cash leaves your bank. Then you have to take into account that some of these customers and vendors will have terms (when their bills are due) – which will always have a direct impact on your cash flow.

Because of this, managing cash flow is a very difficult process if you do not have a proactive approach to your bookkeeping and accounting. Lastly, the longer you wait to input your information, the harder it is to manage the cash.

My company is cash struggling – what can I do to fix the situation before it gets worst?

When it comes to cash shortages, there isn’t a one fix solution; but rather, it is a series of changes coupled with financial discipline. Most cash shortages are a culmination of issues – it is important to identify if your cash shortage is a symptom or a cause.

To do this, you need to evaluate your company’s culture, management style, worker efficiency, and so on to see where the issue is stemming from. Example: Poor management that create a lot of waste will definitely impact your cash flow – but the cash shortage is, in this case, is only a symptom of the overall problem. So it is important to diagnose it correctly.

If, like many small business owners, you draw from your company in order to support your standard of living – then the draw is the cause of your cash shortage. These, sometimes are much harder to fix as it requires financial discipline from the owner.

Often times, I require small to mid-size business owners to have both a personal and business budgets. These budgets help in ensuring the owners and the business stay in sync with one another – setting a definitive spending point for both. But the hardest part is not using the company credit card for coffee, snacks, sodas, and so on. It’s the small charges that adds up quick.

What is “Organic Cash Flow” and why is it different from normal cash flow?

Organic Cash Flow is a relatively new word. In essence, it is your normal cash flow. But when it comes to managerial purposes, organic cash flow refers to the cash flow that the company currently generates without any additional changes.

When it comes to increasing organic cash flow, you are not looking at increasing working capital as stated above. Instead, you are looking at ways to free up the cash flow so it can be put to better use.

Things that impact organic cash flow are usually liability related – loan payments being the biggest one in America. If you generate $1,000 and pay $600 to a loan; your cash flow is $1,000, but your organic cash flow is only $400.

Generally, accountants will assess a company’s cash flow then determine its organic cash flow. Decisions are then based off of that organic cash flow – can a new piece of equipment be added? Should the loans be refinanced to free up the cash? Can other companies provide a better quote? And so on.

In short, Normal Cash Flow is often your total cash flow (how much your company brings in during a week/month/quarter/year). Organic Cash Flow is the cash left over after paying vendors, lenders, and such – and is it enough to accomplish future growth or will the company plateau out because it doesn’t generate enough cash? These are questions you need to ask yourself.