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Capital Expenditure, an Easy Explanation

Some time ago a friend of mine asked me, 'What is the capital expenditure?' And I realized that although we have discussed a lot of things in this website, but we has never discussed about capital expenditure, or commonly abbreviated as capex. While in fact, the factor of capex is important in analyzing the prospects of a stock, since it answered the question, 'What is the company doing to gain additional revenue/profit in the future'. Therefore, we will also discuss it here, of course, with some easy words. Here we go!

Capex is the amount of money spent by the company for a certain period (eg one year) for the purchase of certain assets (usually physical assets) or increasing the production capacity of existing assets, with the aim of improving the company's operational performance which ultimately increasing the revenue/net income. For example, if you have a restaurant and you budgeted US$ 100,000 for this year (2015) to open a new branch and buy tables, chairs, plates, to cooking tools, then you can be said to have issued capex of US$ 100,000 for the fiscal year of 2015. The goal? To increase the income of the restaurant business you have, that with the opening of a new branch, you may expect that the restaurant’s revenue will increase.

From the above definition we can conclude that if a company set a large capex in a certain year, then it means that the company is expanding its business, wherein if the expansion is successful, the revenue and net income in the next year (or the next two years) will increased significantly. This is why every time the analyst or reporter interviewed the director or corporate secretary of listed companies, one of the questions is, 'How much is the company's capex for this/next year?' Because if the capex is large, let say about 100% of the company’s net profit in the previous year, then there will be an impression that the company has a promising future, because it is growing to earn a larger income in the future.

Now, as an investor who holding the shares of a particular company, have you ever ask this question? This year the company has made net profit of US$ 10 million, in which US$ 3 million has been distributed to the shareholders in the form of dividends. Then, what about the remaining US$ 7 million? The answer is of course, the funds will be used by the company to develop the business, whether it establish a new plant, open a new branch office, acquire a company, and so on. However, the next question is, how is the progress of the establishment of the new plant? Because only because the company has the money that will be used for establishing a new plant, then it does not mean that tomorrow, that new plant will be immediately ready to operate, right? Therefore the information about capex is required, because it will explains to investors that the company at this year will spend a number of funds (which is taken from retained earnings of US$ 7 million earlier) to set up a new plant, where at the end of the year the new plant will be ready to serve. In essence, in this year the company will not let these US$ 7 million to be stayed in the bank for nothing, but would soon be used for business developments.

Based on the above explanation, it can be said that a good company is the company that have cash in a relatively small amount in its balance sheet, where every time they earn cash (net income in a given year), then the funds, after reduced for dividends, are immediately used to buy assets, etc. no later than next year. A company should holding cash of about 10% only of the whole assets. If more than that, then there will be an impression that the company are 'lazy' or too slow in empowering their cash assets to be something productive.

In my research, in IDX there are at least three kinds of companies based on the amount of its capital expenditure budget. The first is the company that set capex according to its ability, ie 1. Based on the cash that available, and also 2. Based on time of works. For example, Semen Baturaja (SMBR). For 2015, the company set capex of Rp900 billion which is fully allocated to increase the capacity of the company's existing cement plants, and also to set up a new cement plant which, according to plan, will ready to serve at 2016. Due to the company's internal cash position (cash funds of their own, not the result of a loan) of Rp1.8 trillion, the company did not need to take a bank loan. Actually, if possible, the management of SMBR might had a plan to spend Rp1.8 trillion in just one year alone (in the form of capex), to set up a new plant. However, setting up a cement plant requires time of at least 2 to 3 years, so the available cash could only be used gradually.

The second is the company that set capex exceeding its ability. Like, the company has cash of Rp100 billion, but its capital expenditure in a given year can be up to Rp200 billion, by taking a bank loan or issuing bonds. Example, Bumi Resources Minerals (BRMS), a subsidiary of Bumi Resources (BUMI). Several years ago, ie in late 2010, the management of BRMS announced that the company set US$ 581 million for capital expenditures during the next three years (2011, 2012, and 2013). For the first year ie 2011, the capex was US$ 240 million.

But how much cash available at the company’s balance sheet at the time? Only Rp914 billion or less than US$ 100 million, because the company’s net income for the year 2010 was also only Rp764 billion or about US$ 70 million. So the company had had to take loans from banks. However, in this case those large capex is actually put the company at risk, because if the development works have failed (remember that just because a company spend some money to build a new plant or to open a coal mine, then it does not mean that the construction progress is guaranteed to run smoothly), then the company does not obtain the increase in revenue, but still have to pay interest on bank loans.

The third is a company that doesn’t set capex but only a little, usually because the company has matured and could do nothing but pay dividends for shareholders. For example, Unilever Indonesia (UNVR). For fiscal year 2014, the company only allocates Rp1.4 trillion to expand the ice cream business, while the company's net profit in the previous year (2013) was Rp5.4 trillion (but all of the money is used to pay dividends).

So in conclusion, a good company is the company that set its capex in a reasonable amount, ie according to the ability of the company, no more and no less. A company may take a loan for its capex, but must with prudence or the risks become greater, because there is no guarantee that the expansion plans would succeed. Meanwhile, if a company only set a small capex like UNVR above, then it means that the company did not offer further growth of its net assets in the future.

During this time, I rarely analyze a stock from the side of its annual capital expenditure, because information about the capex only available in newspapers/internet media, while I don’t like reading news. Moreover, when a company at the end of a particular year set a capex of Rp100 billion for next year, for example, then the realization of the cash spent is not necessarily Rp100 billion too, but could be less or more. That's why a number of capex may means nothing. However, if you want to know what is a company doing for the incoming years, you can read the material of public expose that can be downloaded from the And for me, that’s enough.

Okay, I’ll see you again next week.

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