After a detailed understanding on the various types of expenses (https://rajshankar.wordpress.com/2014/01/03/finance-for-entrepreneurs-what-are-expenses/ ) that a business incurs, let us try to quickly appreciate the difference between the two terms: expense and investment.
Expense and Investment both incur a cash outflow. Technically an expense is fully charged to the current Profit/Loss Account (or Income Statement), an investment is fully added to the Balance Sheet (https://rajshankar.wordpress.com/2013/11/08/finance-for-entrepreneurs-what-is-a-balance-sheet/ ) and the outflow is charged to the Income Statement in proportion to the utilization of the invested asset. Because of their inherent different, an expense is a drain on the current year’s profit and does not necessarily add to the Assets in the Balance Sheet. The investment in all probability adds first to the Assets of the Balance Sheet and then a small portion of it is brought to the Income statement (https://rajshankar.wordpress.com/2013/11/01/finance-for-entrepreneurs-what-is-a-profit-loss-statement/ ) every year based on the utilization of the Asset or based on its expected useful life. If you did not understand any of the above – ignore and read on. You will understand it after reading the below or when you return to this after a few more lessons (Weekly Lessons on Finance for Entrepreneurs Delivered every Friday on this blog).
While both expense and investment incur a cash outflow, the reason why it is done is quite different. Expense is a term used for purchases where the usefulness of the purchase is utilized by the enterprise in the immediate future. Investment is a term used to refer to outflows incurred wherein the usefulness of the purchase is utilized by the enterprise over a period of time.
Let’s understand using an example: Fuel (either Petrol or Diesel) is generally purchased by an enterprise for running one of its vehicles. They are used to run the vehicle today or this week. The usefulness of the fuel to the business is immediate or in the near term. Thus ‘Fuel’ is classified as ‘expense’. Businesses buy vehicles for the transport of their products or personnel. This vehicle generally has usefulness to the enterprise for a long period of time. Hence the vehicle is bought with the rational that it will be used for say ten years. Hence the cost of the vehicle is not called as expense, but is added to the ‘Assets’ side of the Balance Sheet. But since it has a life of ten years, a tenth of the cost of the vehicle is brought to the annual expenses of the business (that is to its Income Statement) every year. The term used to refer to such expenses which are brought from the assets to the Income sheet is called ‘Depreciation’. We will learn more about ‘Depreciation’ and similar terms later, but for now please focus on learning the difference between an ‘expense’ and an ‘investment’ and how they are charged to the financial statements by accountants.
As an entrepreneur you will also be lured to buy assets when you start making larger profits, but you will have to review and make rational decisions on large value purchases which result in investments. If the usefulness of the asset dies away faster than predicted (which in today’s world seems to be the trend), a large portion of the assets will result in poor business decisions in the future as well. It also reduces the adaptability of the enterprise. Hence as an entrepreneur, attempt to see if you can convert all non-core business investments into expenses – it will serve the best interests of the business in the long term.
Think about it!