What is Invested Capital?
Invested capital is the investment made by both shareholders and debtholders in a company. When a company needs capital to expand, it can obtain it either by selling stock shares or by issuing bonds. Shareholders are people who have purchased stock in a company and debtholders are those who have purchased bonds.
Uses of Invested Capital
For a company, invested capital is a source of funding that enables them to take on new opportunities such as expansion. It has two functions within a company. First, it is used to purchase fixed assets such as land, building, or equipment. Secondly, it is used to cover day-to-day operating expenses such as paying for inventory or paying employee salaries. A company may choose invested capital funding over taking out a loan from a bank for several reasons.
For example, when a company issues stock shares, it has no obligation to issue dividends. This makes it a cheap source of capital compared to paying interest on a bank loan. A company may also prefer to obtain funding through shares and bonds if they do not qualify for a large bank loan at a low-interest rate.
For an investor, invested capital is evaluated using metrics such as the return on invested capital (ROIC) ratio. This ratio is used by an investor to determine the value of a company. A relatively higher ratio indicates a company is a value creator and is capable of utilizing invested funds to generate higher profits, as compared to other companies.
By dividing revenue by capital invested, the ratio shows the ability of a company to drive sales through its capital. A company that has a higher ratio compared to its peers means they are operating more efficiently.
Quick Summary Points
- Invested capital is capital invested in a company by debtholders and shareholders
- For companies, invested capital is used to expand operations and further develop the company. Investors utilize the return on invested capital (ROIC) ratio to assess the efficiency with which a company uses capital
- There two ways to calculate this metric: the operating approach and the financing approach
How is Invested Capital Calculated?
The two ways to calculate the invested capital figure are through the operating approach and financing approach.
The formula for the operating approach is:
- Net working capital = Current operating assets – Non-interest bearing current liabilities
- Goodwill and Intangibles are items such as brand reputation, copyrights, and proprietary technology (computer software)
The formula for the financing approach is:
Worked Example of the Operating Approach
The following is the information for Company A:
For the operating approach, the numbers needed are (1) working capital, (2) PP&E, and (3) goodwill & intangibles. Firstly, to get the net working capital figure, subtract the non-interest bearing liabilities from current operating assets. Next, to get the PP&E, add the manufacturing plant A with manufacturing machinery. Lastly, to get the goodwill & intangibles, add the goodwill amount with proprietary technology. The last step toward getting the invested capital is to add the three categories together.
Worked Example of the Financing Approach
The following is the information for Company B:
For the financing approach, the main numbers needed are (1) total debt & leases, (2) total equity and equity equivalents, and (3) non-operating cash & investments. To calculate total debt & leases, add the short term debt, long term debt, and PV of lease obligations. Next, to get the equity and equity equivalents, add the common stock and retained earnings together. Lastly to get the non-operating cash and investments, add the cash from financing and cash from investing. The last step to get the capital invested is to add the three sums together.
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