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Comfort trap

“This business doesn’t have a clue how to allocate capital. Does it?”

Silence.

My VP of Finance and Head of FP&A knew that I was including them in that. And that we’d have to get smarter and sharper quickly.

We were setting top-down guardrails for the upcoming long-range plan. Just a few weeks after the CapEx committee meeting I shared last week. (The one where 13 mediocre projects were greenlit without a second thought).

The key focus today was how much cash (in total) we would allocate to growth CapEx for next year (and beyond.)

I was still getting up to speed with the business. So we’d spent 90 minutes talking through a bunch of the ‘big ticket’ capital project demands from the business.

I was underwhelmed by what I saw. Hundreds of millions of dollars of high-risk projects in a business that had a poor track record in producing business cases. And an even worse record in executing those projects.

I was already feeling like the growth capital budget should be zero until the execution problem was fixed.

But then the conversation moved on to the roadmap for restructuring costs. Just under $100m over the next five years. I asked the obvious question. “What are these projects? Why are we spreading the restructuring costs over five years?”

“Most of it is for closing down unprofitable parts of the business. The exec has always been reluctant to take that in one hit. They have previously set a limit of $20m per year.”

“What is the total annual losses of these business units?”

“Roughly $30m.”

“OK, that’s pretty interesting. And how much of those restructuring costs would be cash costs?”

“About 25%.”

“Sorry, did I hear you right?”

“Yeah, it’s about $25m of cash costs. The other $75m would be asset impairments.”

I let out a volley of expletives, which I’ll redact to keep this suitable for work.

We reviewed the restructuring plans the business had built. They were good… much better than their CapEx plans.

“You are telling me it would cost us $25m in cash restructuring costs, to add $30m of continuing profit? 10 months payback. And we were going to let that take 5 years because we didn’t like the accounting implications?”

“Pretty much.”

More expletives.

“That is not how I work. And it’s not how we will work going forward. Every single one of these restructuring projects has a better, more reliable, payback than even the best CapEx project you’ve just shown me.

And the restructuring will simplify the business, strengthen the cash flow quickly, and produce a stronger balance sheet for funding CapEx in the long term. By which time we will be equipped to execute.

We should have spent this meeting talking about those restructuring plans and nothing else. Let me be clear. I’m not spending a penny on growth CapEx until the business fully commits to that restructuring program in full. I don’t care about the size of the asset impairment, it’s sunk.”

This business was so fixed in thinking about capital in different buckets, and the associated accounting, that it was making terrible decisions. The tail was wagging the dog.

“But, what will Robert say?” Robert was the CEO.

“I think he’ll be as stunned as I am. Leave Robert to me.”

Pushing the (CapEx) Envelope, But Not Your Luck

This is part two of a five-part series breaking down how CFOs should manage capital expenditure (CapEx).

Last week, we focused on the mindset you need to properly think about CapEx.

This week, we are going to dive into how you should set the overall CapEx budget.

Note that we’re purposefully not talking about individual projects yet. Doing so too early leads to ‘pet project’ battles before we’ve even set the total pot. We are deciding how much money will be available in total for capital spend first.

The Capex Envelope

I refer to the overall available funding for Capex as the ‘Capex Envelope.’ I heard a former CFO I worked for use it early in my career, and it stuck with me.

I like it because it’s visual and people understand visual metaphors. They understand that envelopes come in different sizes, but once selected, their boundaries are fixed. And that there is only so much you can stuff in an envelope.

But also that an envelope is there to be used. Plus, once that envelope is closed, IT’S CLOSED.

So, let’s get into how you decide on the size of the CapEx envelope.

How Big Should the Envelope Be?

Standard letter sized? Maybe the one the hotel key card comes in? Or perhaps the type with the metal clasp?

This is both art and science. A common mistake among finance teams is to approach it purely ‘scientifically.’ But to do so in a flawed or half-a**ed way.

So let’s present a framework for sizing the CapEx envelope.

Getting the total capital budget right lies at the intersection of these four variables:

Let’s define each of the four a little more precisely:

Company Strategy

CapEx is one of the most important resource allocation decisions a business can make. So the approach to CapEx MUST be in lock-step with the overall strategy.

And these aren’t just words. Your strategy should express the strategic unit economics for your business, and the role CapEx plays within that. Is your goal to:

• Reduce cost per unit?

• Grow volumes and capacities?

• Protect existing margins?

And:

• Are ESG investments important to your business, or not?

• Are you trying to be at the cutting edge of technology? Or are you happy to be in the pack?

• Are you vertically integrating? Or staying in your lane.

• Etc.

All of these are big questions about business strategy. And influence the extent to which you have a CapEx-heavy or CapEx-lite strategy.

This piece from last year dives into strategic unit economics.

Availability of Capital

The size of your CapEx envelope has to be influenced by your business's access to capital. There are three sources (for this purpose):

1. Cash on hand

2. New funding (debt or equity)

3. Generated cashflow (MFCF)

Each of these sources will have different costs and levels of capacity for your business. So it follows that the more cheap capital you can source, the more aggressive you can be about your CapEx plans.

Demand for CapEx

It goes without saying that demand for CapEx must play into the overall size of the envelope. But we should probably define ‘demand’ in this context. Because let’s be honest, every leader will demand $ for sh*t they don’t need if left to their own devices.

It is the demand from the business for investment in projects that can deliver a good quality return. Which means you should be looking at not just the business cases, but also the ability of the business to execute those plans.

It really boils down to this: how confident are you that the business could turn any CapEx you invest into a good return?

The mix of maintenance to growth CapEx is important here too (but more on that later).

Quality of Alternatives

Now, here is the punchline. Resource allocation decisions are about choices. And CapEx is no different.

When you choose to invest a dollar in CapEx, you are choosing to NOT invest a dollar in something else.

All investment has an opportunity cost. This is a question of capital allocation and the alternatives available to the business outside of CapEx. In the Working Capital example above, there was a much more attractive alternative to CapEx investing in the form of an operational restructuring. But it could be debt paydown, M&A, share buybacks, etc.

For example, in 2016, Caterpillar was in a capital crunch and had to choose between new fleet investments and protecting the dividend. Instead of spending on CapEx, they preserved cash, kept their dividend steady, and saw a strong market reaction. Every CapEx decision has an opportunity cost. And sometimes, simply not spending ‘just in case’ is the smartest move.

There is a lot more to say here (it could be a post in its own right). But we explored this trade-off in detail in a series on capital allocation last year.

Balancing the Equation

Defining the CapEx envelope is an exercise in getting the right balance between these four influences. If any one part isn’t properly considered, you could end up with the wrong size envelope:

In my experience, most finance teams don’t get the balance right:

• Leave the business strategy out of your analysis and you’ll end up with an envelope that works for finance but not for anyone else (the most common failing)

• Fail to consider the availability of capital and you’ll overspend

• Ignore the alternative uses of capital, and you’ll over or under-allocate to CapEx vs other capital pots

• And if you don’t understand the capital demand, you might underinvest in CapEx, or over-invest just because you have the available capital

More Than One Envelope?

Next, we need to think about time. The CapEx envelope needs to be specific to a time period.

Oftentimes, I like to think of this in two time horizons:

• Annual: how much do we plan to spend this financial year, and next financial year?

• Long Range Planning Horizon: how much do we plan to spend in total over the entire long-range planning horizon (typically 3-5 years)?

Setting the Envelope in Practice

That’s the theory. But how does this work in real life? Where and how does the CapEx envelope get set?

Defining the size of the CapEx pot is a fundamental part of the FP&A cycle. Most of this happens in the Long Range Planning process (LRP).

We dive into LRP in detail here. (And we will cover it again in a series in a few months time)

LRP is the process that builds a multi-year high-level financial plan for the business. A strategy written in numbers, not words.

The LRP process isn’t just for financial forecasting, it’s the CFO’s chance to set CapEx constraints (and others). And to anchor executive discussions before detailed project planning begins.

It is the perfect opportunity to review all options open to the business. And use that to set the guardrails for the total CapEx spend for a given period of time.

In practice, this can feel a bit like an internal negotiation. A tension between a bottom-up expectation and a top-down reality.

The FP&A team will always receive ambitious requests from the business. And the exec team will want to push for aggressive targets. Finding the right size envelope means resolving this push-pull dynamic to kind of ‘spiral in’ towards the right answer.

And oftentimes that same debate happens in the C-Suite. I have had many heated conversations with COOs, CEOs, and board members about what is affordable. But these are important conversations. It is HOW you force alignment to the center of the Venn diagram above.

A good LRP process will, at a minimum, set you up with a clear CapEx envelope for next year, and for the LRP period in total.

But most importantly, it anchors the business to a certain level. And if you have gone through the LRP process properly, you will have taken the business with you on the journey, so they will understand the constraints.

The Dynamic Envelope

All that said… the envelope does not have to be fixed. It can be, but doesn’t have to be.

A fixed envelope would be an example of a static limit i.e. “we are going to spend no more than $50m on CapEx next year.” Or “we are going to spend $150m across the 3-year life of this LRP.”

But you could define that fixed envelope in the context of a financial metric: “We will spend up to 5% of revenue” or “the average of the last 3 years’ depreciation.”

This is a good way to peg the envelope to the strategic unit economics for the business.

But life is rarely that simple. Especially in smaller, dynamic businesses, where investments might be dependent on some trigger.

For example, the CapEx envelope might be connected to landing a specific future funding round.

I have used this framework in the past in turnarounds too. We will set a fairly low CapEx budget (constrained by affordability). But we will also excess MFCF available for additional CapEx. (This is an example where MFCF really comes into its own as a measure.)

An example: the CapEx budget is $80m but for every $1 of MFCF above budget the business generates, we will reallocate 30 cents back into growing the CapEx envelope.

So you can build the CapEx envelope in a dynamic/conditional way. It’s particularly useful in situations where the constraining factor is the availability of capital.

It’s a great way to incentivize the business to outperform i.e. “If revenue exceeds plan by X%, we increase CapEx by Y%.” This ties investment directly to performance and ensures capital allocation adjusts dynamically to market conditions.

But this does need careful management. You’ll need to carefully consider over what time period are you assessing the MFCF v budget, and how and when that unlocks more CapEx.

Maintenance CapEx vs Growth CapEx

As I have said many times in the past, I think about all CapEx in two buckets:

Maintenance CapEx = recurring capital expenditures required to maintain the current level of operating and market position. Included in MFCF.

Growth CapEx = capital expenditure to increase its operating cashflow, or grow the business. Excluded from MFCF.

The word ‘maintenance’ tends to trigger accounting purists here. I know, because plenty of people have written to me confused about this.

So, I will explain this once more.

Imagine you have a chain of coffee shops.

• You have 10 coffee shops, each with 2 machines. 20 machines in total (quick math 😎).

• Those coffee machines get replaced on a 5-year cycle, i.e. you need to replace 4 machines per year

• You are opening 1 new shop per year. So, you need to buy 2 machines to fit new stores per year.

In a typical year, you are buying 6 coffee machines per year, 4 replacements, and 2 for new stores.

The 4 replacements are maintenance CapEx. That spend is needed to maintain the existing asset base. And current operating cashflow.

The 2 machines needed for new stores are growth CapEx. Expanding the asset base, and future cash-generating capacity of the business.

Any spend to repair or maintain existing equipment is NOT CapEx at all. That’s an expense in the income statement.

Why is this differentiation important?

Because you need to plan capital differently for the two. Maintenance CapEx is less discretionary than growth CapEx. If you fail to invest in maintenance CapEx on a regular cycle you will start to destroy your base earnings capacity i.e. eventually your equipment will fail, and your business becomes worthless.

That means you typically prioritize maintenance CapEx first, out of necessity.

This can have profound effects on your capital available for growth. Especially if your mix of maintenance CapEx is high.

Let’s say your maintenance CapEx is $300k for a year. All essential.

And your total CapEx envelope is $500k.

Your Growth CapEx budget is therefore $200k. But now let’s say something changes and you have to cut that total CapEx envelope by $100k (to $400k). That will slash your growth Capex budget in half from $200k to $100k.

For this reason, I like to think about the CapEx envelope split into two: one for Maintenance CapEx & one for Growth. Two envelopes, if you like. Each with its own rules.

Net-net

Setting the CapEx envelope is an art and science. It’s not mechanical like some other parts of the CapEx process (which we will touch on in future weeks). It’s about defining the right total level of capital investment.

Once you are clear on the parameters for your CapEx envelope, you can hardwire it into your financial policy. This is especially important if there is some conditionality in defining the envelope.

If you missed last year’s piece on setting a financial policy, you can find it here.

But once we have got the size of the envelope defined, we need to work out what projects make it into the envelope.

And next week, that’s where we are headed.

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