Capital Expense (Capex) plays a major role in the free cash flow situation of most companies. For this reason, it deserves specific attention within corporate processes. This blog reviews how to plan the right Capex level to sustain future enterprise development, design a request and approval process, and control the level of spend.
Planning the right Capex level for future enterprise development
Investment is part of a company’s long-term development. For this reason, Capex should be focused on entrepreneurial activity. For example, to open new markets, launch new products and secure a company’s strategic competitive advantage. However, Capex is also limited by the cash levels available or by the company’s ability to refinance itself on the market.
Owner-managed companies are less constricted by external opinions than publicly listed corporations when it comes to refinancing, but they often face some treasury limitations. For example, in the early 1930s, André Citroën decided to invest considerably in a new production facility for his new vehicle, the Traction Avant. By doing this, he pushed his company to its financial limit.
In large corporations, Capex planning is usually based on strategic goals and on financial key performance indicators (KPI’s) such as the economic value added (EVA). Then the overall Capex spend level gets fixed. Investments are categorised and prioritised since all projects cannot be financed at the same time e.g. strategic development, product development, productivity improvements, legal requirements, sustainability and health and safety.
Prioritisation often results in a range from A to AAA, while an A to C list would be much more useful. At this stage, a business and risk assessment of all the projects is a good process to reduce the long project list into one that fits within an affordable budget. This approach is more effective than a radical cut from the top.
Organising the approval process
Many medium to large companies use the combination of two things—delegation of authority (DoA) and an appropriation request system. The DoA involves different approval levels depending on the value and is more efficient than an autocratic owner-based system. It requires the responsible managers to be accountable whilst allowing adequate control of the money by requiring at least two people to approve.
I have encountered during my career different DoAs depending on the investment thresholds or whether the project was product or non-product. The result is an approval matrix. In this matrix, the highest delegation is given for projects of lower strategic importance and limited financial risk, while strategic and costly projects require top executive approval.
As there are numerous methods that exist to measure the financial viability of an investment project, companies tend to use KPIs for appropriation requests. These are easily understandable for non-finance managers. The KPIs used are commonly the payback period and the net present value (NPV). This allows finance and operational managers to assess the financial impact of the investment alternatives quickly.
Implementing a strict control for investments
Capex priorities and project timing must be respected. This requires continuous monitoring of Capex spend and an accurate estimation of project approval dates and project delivery timelines. As a consequence, approval requests must be sought early to avoid delays, especially for major investments.
Unfortunately, in real life, this is not always the case. Some companies are able to reschedule their spending plans to accommodate projects whose timings extend beyond the current business year. Other companies, however, will or cannot accept such delays.
This can lead to either a request for re-approval or the project being considered a loss. This is so as not to endanger the company’s refinancing capacity in future years. An even worse reaction however would be when the company decides to spend considerably more on questionable investments to using up excess Capex budget. Forgive me, but public administrations have a tendency to act like this.
Measuring return on investment (ROI) can be a challenge, especially with market conditions changing rapidly. Measuring ROI is however necessary in order to measure the effectiveness of Capex and to learn from any mistakes made. It is also part of the continuous improvement process. Finally, it ensures that the assumptions of future investment projects will become more realistic.
The article was first published in Unit4 Prevero Blog