What's the difference between growth capex, maintenance capex and internally financed capex?
What's the difference between growth capex, maintenance capex and internally financed capex? Why is it such an important concept to understand when selling a business?
There are generally two reasons companies spend money on capital expenditures (capex): to grow the business, and to maintain the business. Once a company determines it needs to make a capex investment it must decide how to pay for the capex, either using company cash or debt. Let’s explore each element of capex in more detail to get a better understanding:
Maintenance Capex: The necessary expenditures required to keep existing operations running smoothly. Perhaps a new conveyor belt for the old machine, or new computers to replace the outdated technology. These expenses don’t attract new customers or create the capacity for a bigger business; they just enable the company to keep running at status quo.
Growth Capex: The discretionary investments used to attract new customers or create the capacity for a bigger business. Perhaps a new customer requires you upgrade your software before signing a contract, or maybe you need another machine to process all the upcoming orders from new customers. These are the expenses/investments in additional assets to help facilitate growth.
Internally Financed Capital Expenditures: Spending internal cash (instead of debt) to pay for capex. When banks are determining your credit-worthiness, they are evaluating all the sources & uses of cash. Capital expenditures is a big use (drain) of cash for many companies, particularly manufacturers. The more cash is spent on capex, especially growth capex, the fewer funds are available for debt payments. Capex financed with external cash (bank debt or owner equity) doesn’t reduce company’s cash flow, but capex financed with company cash does. Internally financed capex is part of the fixed charge coverage ratio (FCCR) used to determine a company’s ability to repay its debt. The bank often asks for an estimate of internally financed capex because that number won’t be included in any financial statement, but is necessary to calculate your company’s ability to repay debt.
If you have capital expenditures, it’s helpful to keep track of how much was spent to grow versus maintain your business, and how much was financed with company cash instead of bank debt. This analysis and information is very useful when preparing to sell a business. The differentiation between these capex elements will help a buyer assess the free cash flows of a potential acquisition target.