Invested Capital

Invested capital is the total amount of money a company raises via share sales and bond issuances. It helps companies to purchase fixed assets and cover operating expenses.
EXPLORE FUNDS
Invested Capital
EXPLORE FUNDS
3 min
11-June-2024

Invested capital refers to the total worth of equity and debt capital acquired by a company, including capital leases. Return on invested capital (ROIC) evaluates a company's effectiveness in utilizing its capital to generate profits.

Can a business sustain its activities if its earnings fall below the cost of capital? The answer is no. If a company does not earn more than its expenditures, it implies that it is making a loss. It consequently uses more of its invested capital to run its day-to-day operations, gradually destroying its invested capital.

If a company wants to run profitably and does not want to destroy capital, the rate of return on its invested capital must be relatively higher than that of the cost of invested capital.

But what is the meaning of invested capital? Let us understand its meaning and significance in greater detail.

Also read: SIP investment

What does invested capital mean?

The invested capital refers to the total amount of funds a company raises by either issuing bonds (called debt financing) or selling its shares (called equity). The persons or entities that buy shares of a company are called shareholders. However, those who buy company bonds are known as debt holders. A company can raise funds by issuing bonds, selling shares, or a combination of both financing routes.

Most companies use invested capital for:

  • Buying fixed assets
  • Capital expenditure
  • Meeting their working capital requirements

In a balance sheet, invested capital is not a line item. This is because items such as shareholder equity, capital leases, and debt are listed separately in the financial statement of the company.

Formula to calculate invested capital

You can calculate invested capital (IC) by following two approaches. While one is the financing approach, the other is the operating approach.

  • Financing approach formula
    The formula used to calculate IC by using financing approach is:
    Invested capital =
    (Total debt of the company) + (Common equity of the company) + (Preferred company stock) + Equity equivalents
  • Operating approach formula
    The formula used to calculate IC by using the operating approach is:
    Invested capital =
    (Total current assets of the company) - (The company’s total operating liabilities) + (Total non-current assets of the company)

You can use the value of invested capital to calculate:

  • Activity ratio of a business
  • Economic profit
  • Return On Capital Employed (ROCE)

A 2% or more ROIC is considered a good return. As an investor, you can think of it as a threshold level to expect a good return from your investment. If the ROIC is less than 2%, you should try to square off your position and cut your losses.

Invested capital with an example

Invested capital is money raised by a company to meet certain requirements. It is usually used to buy fixed assets like machinery, buildings, land, etc. Sometimes, companies use invested capital to pay salaries of employees or as inventory payment.

Example

Suppose a company wants to expand its operations quickly to match the increasing demand for its products. It requires Rs. 200 crore to meet its needs, but its existing capital is not enough. Therefore, it sells shares and issues bonds to raise Rs. 200 crore from the shareholders and debt holders. This raised fund is called invested capital. The company uses the invested capital to buy land, buildings, and machinery.

Uses of invested capital

Invested capital helps a company meet its long-term needs, such as purchasing land to set up a factory, buying machinery, building a factory unit for expansion, etc. Mostly, these funds are raised so that the company uses them properly to expand and, in turn, generate returns for its investors.

An investor can understand how efficiently the invested capital is used productively by checking the return on invested capital. Shareholders can calculate ROIC by dividing the NOPAT (Net Operating Profit After Taxes) by the invested capital (or the raised fund from the shareholders or debt holders).

How to calculate invested capital?

You can calculate the invested capital of your company in 3 ways. They are the financing approach, assets, and net operating assets. But how is the calculation done? Let us find out:

1.Financing approach

The first method of calculating invested capital is the financing approach. Under this approach, you can calculate invested capital by adding total equity, total debt, and non-operating cash.

The total equity includes:

  • Equity of shareholders
  • Preferred stock
  • Equivalents of equity

To calculate the total debt of a company, you have to add all debt instruments and interest-bearing liabilities. It includes:

  • Commercial paper
  • Capital leases and others

You can add the non-operating cash items such as:

  • Cash
  • Cash equivalents
  • Assets of discontinued operations
  • Marketable securities and others

2..Assets

When invested capital is calculated in terms of assets, it includes the addition of working capital, plants and equipment, other operating assets, and goodwill. To calculate working capital, you can subtract current liabilities from current assets.

3.Net operating assets

There is a third approach to calculating invested capital. According to this calculation procedure, invested capital equals net operating assets. In this approach, you have to subtract the liabilities used in business operations from the assets you have used in business operations to get the value of invested capital. Net operating assets include three major assets:

  • Inventories
  • Accounts receivable
  • Intangible assets

But which one should we consider? For simplicity, let us consider the following formula to calculate the invested capital:

Invested Capital = (Total Equity) + (Total Debt) + (Non-Operating Cash)

Let us now check what equity capital and debt capital are:

Equity capital

Invested equity capital is the total money that has been invested by the shareholders in a company by buying stock shares. That is why it is also called shareholders' capital. On the balance sheet of a company, it is an important line item. You can calculate it by finding the difference between a stock’s par value and the price you have paid as an investor for the stock.

With the help of invested capital, a company can:

  • Expand its operations
  • Buy fixed assets
  • Explore new opportunities

A company sells its shares to raise invested capital.

Debt capital

Debt capital is the total amount of money a company borrows to fund its operations. Companies usually borrow the money as collateralised loans, which they repay with interest at a future date in the short run or long run. When such money is collected as a loan from investors, debentures are issued by the business.

How to analyse invested capital

You can analyse invested capital by using various metrics, including:

  • ROIC (Return on invested capital)
  • ROA (Return on assets)
  • Gross margin
  • Cash flow margin
  • Operating margin
  • Gross margin
  • IRR (Internal rate of return)

Let us consider an example. Suppose you are using the ROIC formula to calculate invested capital. If the value of ROIC is higher, it shows that the company is more efficient than its peers as it uses less funds to generate higher profits.

Also read: Compare mutual funds

Benefits of tracking invested capital

The biggest advantage of tracking invested capital is to check whether the company is using it productively. If the return generated is well above the cost of operations, you will know that the capital is being used in such a way that it will provide the investors profit in the long run.

Summary

For an investor, knowing the concept of invested capital is crucial. A better understanding of this metric will help you understand the extent of funds the company has raised from shareholders and debt holders. You can calculate the ROIC (Return on Invested Capital) and check whether the company is utilising the raised funds productively. Thus, you can better understand the company's financial health and if it can generate profits or future value for the shareholders by checking the ROIC.

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Frequently asked questions

How Do You Calculate Capital Invested?
You can calculate the capital invested by using a formula. The total invested capital is equal to the (total current assets) - (total operating liabilities) + (total non-current assets). The invested capital is equal to (total debt) + (common equity) + (preferred stock) + (equity equivalents). Capital invested is equal to (total equity) + (total debt, which includes capital leases) + non-operating cash.
What Is an Example of Capital Invested?
Invested capital is the money that a company raises by either issuing stocks to stockholders or bonds to debt holders. Here is an example. Suppose, there is a private company called ABC that manufactures plastic chairs. Due to the increase in demand, it wants to expand its manufacturing capabilities by purchasing land and required machinery. The total amount of capital needed for expansion is Rs. 2 crore. As the company does not have the capital for fast expansion, it wants to raise funds by selling its stocks to the general public. Hence, it sold 1 lakh shares to raise Rs. 2 crore. This fund of Rs. 2 crore raised by selling shares is the capital invested.
What Is a Good Return on Invested Capital?
A 2% or higher return is considered as a good return on your invested capital. If a company’s return on invested capital is less than 2% then the company is considered to be destroying capital. If the ROIC is higher than 2% of the weighted average cost of capital (WACC), then the company’s management is considered to be using the raised funds efficiently and will eventually convert the investment into a profit. A 10% or more ROIC is considered a strong return on invested capital.
Is invested capital the same as total assets?
Yes, the invested capital is the same as the total assets. This is mainly because they refer to the total of a balance sheet’s left-hand side.
Is invested capital an asset?
Yes, invested capital is an asset because the funds raised from shareholders and debt holders are used to meet various needs of the business.
Where to find invested capital?
You can find invested capital in the layout of "Separation of Operations and Finance” in the balance sheet. The listing of the total invested capital is done with other heads such as the total non-current liabilities, total operating liabilities, and total current assets.
What is investing capital?
Investing capital is the total amount of funds that a company raises by selling stock shares and issuing bonds.
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