When business owners operate their businesses, they will collect money for selling a product or service. They will then take that money and pay for necessary expenses. The money left over is the money they have to take home or pay loans.
The expenses a business has to pay have some interesting categories. Consider a restaurant owner who serves food. She will need to purchase the ingredients to prepare meals. Those purchased items are an expense, or more specifically, the cost of materials or cost of goods sold.
That same restaurant owner will need to pay a staff for cooking and waiting on customers. She also needs to pay for lights, water, garbage, etc. These are what we call operating costs or operating expenses.
Then there is another kind of expense that may not seem readily obvious. What if the windows are old and need to be replaced? Or, what if the roof needs to be fixed or the parking lot needs to be repaved? Those types of expenses are called capital expenditures, or CAPEX for short.
Cost of materials and operating expenses may vary over time, but they are relatively predictable. If you are operating a restaurant, you will know how much food you will need to prepare orders and how many employees you need to hire as well. Capital expenditures, on the other hand, can be more challenging to predict. You may know that the building will need to be repaired, but you aren’t sure when.
As a lender, you can review the financial performance of the restaurant, and clearly see the cost of goods sold and operating costs. But, you may not see capital expenditures if they happened. A capital expenditure is not necessarily recorded as an expense! Instead, accounting rules require that capital assets be depreciated over their useful life. If a piece of $100,000 equipment was purchased, and it is expected to last 10 years, then the business owner might have to expense $10,000 a year as depreciation over 10 years, instead of showing the full expense in the first year.
How does a lender anticipate what capital expenses, or CAPEX, a business will be faced with? Even if equipment has a 10-year life, it might fail before 10 years or last well beyond 10 years. No matter what happens, you want your borrower to be prepared. Should the borrower be faced with an unanticipated capital expenditure, then the borrower will rely on her savings to pay a big ticket item, or need financing.
With large projects, we try to be proactive, and require the borrower to save some money every year in case an unexpected CAPEX item arises. But, the key issue is CAPEX is often unanticipated, so it is hard to say with any precision how much the borrower should be required to save on a regular basis. Therefore, the targeted savings is an estimate, or a best guess. In this case, the borrower has some ground to debate what may be an appropriate amount, and the lender will need to negotiate a practical solution where both parties can find some common ground.