Capital Expenditures and Depreciation

This is a continuation of our business expansion to selling frozen foods in our store. We have purchased a large freezer to store frozen foods. Since this item is useful in the long term (more than 1 year), we initially record it only as Capital Expenditures in Cash Flows from Investing Activities on the Cash Flow Statement, and then allocate its cost over time as Depreciation in the Income Statement.

Let say we spend $18,000 on the freezer. Assume it will last 3 years (hopefully longer). We record a cash outflow of $18,000 in the Cash Flow Statement and a “Depreciation” of $6,000 in the Income Statement each year.

Year 2Year 3Year 4
Capital Expenditures on Cash Flows from Investing Activities18,000
Depreciation on the Income Statement6,0006,0006,000
Book Value12,0006,0000

The freezer is a long-term asset (more than 1 year), so the freezer is recorded on the Balance Sheet as Property, plant and equipment with a carrying value of $12,000.

Balance SheetYear 1Year 2Explanation
Current Assets
Accounts Receivable0.0045,000.00
Prepaid Expenses0.0016,000.00
Total Current Assets30,000.0085,104.00
Long Term Assets
Property, plant and equipment0.0012,000.00[Property, plant and equipment] = [Capital Expenditures] – [Depreciation]

12,000.00 = 18,000.00 – 6,000.00
Total Long Term Assets0.0012,000.00
Total Assets30,000.0097,104.00
Liabilities & Equity
Current Liabilities
Accounts Payable0.004,000.00
Deferred Revenue0.0011,500.00
Total Current Liabilities0.0015,500.00
Long Term Liabilities
Total Long Term Liabilities0.000.00
Toal Liabilities0.0015,500.00
Total Liabilities & Equity30,000.0097,104.00

Capital Expenditures cause cash flow to decrease initially. Net Income also decreases due to this Depreciation expense, but the Depreciation is not recorded until the first year after the Capital Expenditures, so there is no immediate impact.

Income StatementYear 1Year 2
Cost of Sales(110,000.00)(150,000.00)
Gross Profit90,000.00130,000.00
Selling and marketing expenses(3,000.00)(7,000.00)
Administrative expenses(50,000.00)(50,000.00)
Operating Expenses(53,000.00)(57,000.00)
Operating Profit37,000.0067,000.00
Other Income / (Expenses)900.00900.00
Interest Income / (Expenses)0.000.00
Profit Before Tax37,900.0067,900.00
Income tax expense (24%)(9,096.00)(16,296.00)
Net Income28,804.0051,604.00

It should also be noted that Depreciation is a non-cash expense, so it is an adjustment in the Cash Flow Statement. It reduces the company’s taxes, but it costs the company nothing in cash. As a result, the company’s cash balance increases.

Cash Flow StatementYear 1Year 2
Cash flows from operating activities
Net Income28,804.0051,604.00
Changes in working capital
(Increase)/Decrease in Inventory0.00(22,000.00)
(Increase)/Decrease in Accounts Receivable0.00(45,000.00)
(Increase)/Decrease in Prepaid Expenses0.00(16,000.00)
Increase/(Decrease) in Accounts Payable0.004,000.00
Increase/(Decrease) in Deferred Revenue0.0011,500.00
Net cash from operating activities28,804.00(9,896.00)
Cash flows from investing activities
Capital Expenditures0.00(18,000.00)
Net cash from investing activities0.00(18,000.00)
Cash flows from financing activities0.000.00
Net Cash from financing activities0.000.00
Net Change in Cash28,804.00(27,896.00)

Impact of Capex and Depreciation to the Financial Statements in a Glance

Impact of Capex and Depreciation to the Financial Statements in a Glance

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