What does Invested Capital Mean?

Invested capital refers to the total sum of money raised by a company through the issuance of securities to equity shareholders and debt to bondholders. It represents the combined worth of equity and debt capital that was raised by a firm, inclusive of capital leases. Invested capital is not explicitly mentioned as a line point in the firm’s financial statements, as capital leases, debt, and stockholders' equity are typically reported apart in the balance sheet.

Explaining Invested Capital

Invested capital is a crucial concept in assessing a firm’s capability to produce economic profit. To earn an economic profit, a company must generate earnings that surpass the cost of raising capital from shareholders, bondholders, and other financing sources. This metric is essential in determining how effectively a firm utilises its capital. Companies employ various financial ratios, such as the Return on Invested Capital (ROIC), the Economic Value Added (EVA), and the Return on Capital Employed (ROCE), to evaluate their capital utilisation.

How to Calculate the Invested Capital?

To calculate the invested capital, there are two common approaches: the operating approach and the financing approach. 

Operating Approach:

The formula for calculating the invested capital using the operating approach is the following:

Invested Capital = Net Working Capital + Fixed Assets + Goodwill and Intangibles

Where: Net Working Capital = Current Operating Assets - Non-interest Bearing Current Liabilities.

Fixed Assets include tangible assets such as land, buildings, and equipment. Goodwill and Intangibles represent intangible assets like brand reputation, copyrights, and proprietary technology.

For calculating the net working capital, you should deduct the non-interest bearing current liabilities from the current operating assets. Then add the resulting net working capital to the fixed assets and goodwill and intangibles to gain the invested capital.

Financing Approach:

The formula for calculating the invested capital using the financing approach is the next:

Invested Capital = Equity + 

Debt + Capital Leases

Where: Equity refers to the value of shares issued to equity shareholders. Debt represents the full debt, including bonds, raised by the firm. Capital Leases include any long-lasting lease obligations.

Add the equity, debt, and capital leases together to find the invested capital.

Please remember that the financial expert of a specific company may have their own unique approach to calculating the invested capital based on the firm’s specific circumstances and industry practices. The provided formulas and approaches serve as general guidelines to calculate the invested capital.

What does the Return on Invested Capital (ROIC) Mean?

The Return on Invested Capital (ROIC) is a profitability and performance ratio that measures the percentage profit a firm earns on its invested capital. It illustrates how efficiently a firm utilises the capital offered by investors to produce income. ROIC is a key metric used in benchmarking to assess the value and performance of companies.

Returns, in the context of ROIC, refer to the earnings generated by a company after taxes but before interest is paid. These returns reflect the profitability of the company's operations. It is important to note that returns must exceed the cost of acquiring capital to create economic value.

How to Calculate the Returns?

The Return on Invested Capital (ROIC) is a measure utilised to estimate a firm’s effectiveness in utilising the capital to produce returns. It quantifies the percentage profit that a firm earns on the money invested by its bondholders and stockholders. 

To calculate the ROIC, the following formula is used:

ROIC = Net Operating Profit After Tax (NOPAT) / Invested Capital

Here are the key steps involved in calculating the ROIC:

1. Determine the NOPAT: NOPAT means the after-tax operating profit earned by the firm. To calculate it, you should multiply Earnings Before Interest and Taxes with the tax rate and can be expressed as NOPAT = EBIT * (1 - Tax Rate).

2. Calculate the Invested Capital: The book value of debt and equity is used in this calculation. Subtract any cash equivalents from the book value of debt and equity to eliminate the interest income from money. The formula for calculating the Invested Capital depends on the specific method chosen, such as subtracting non-interest-bearing current liabilities from total assets or adding the book value of equity to the book value of debt while subtracting non-operating assets.

3. Apply the formula: Divide the NOPAT by the Invested Capital to gain the ROIC percentage.

It is important to note that the book value of debt and equity is preferred over market value for this calculation. Market value may include future expectations and growth assets, which can distort the calculation for rapidly growing companies. Using book value provides a more accurate representation of the current profitability.

To compare the firm’s ROIC to its Weighted Average Cost of Capital (WACC) is very important. If the ROIC is higher than the WACC, it shows that the firm generates returns higher than the price of the capital. And if the ROIC is lower than the WACC, it suggests that the firm earns a lower return on its projects compared to the cost of funding them.

The ROIC is a reliable method to see profitability and is viewed as more informative than other ratios like the Return on Assets (ROA) or the Return on Equity (ROE). 

Bottom Line and Key Takeaways

Invested capital plays a crucial role in evaluating a company's profitability and efficiency in utilising the funds provided by investors. It represents the total capital raised by a firm through equity and debt offerings, including capital leases. The ROIC is an important metric that shows the effectiveness of a firm's generating profit on its invested capital. Due to comparing the ROIC to the WACC, companies can define whether they create or destroy value. Calculating the invested capital and the ROIC allows investors and analysts to make informed decisions about a company's financial performance and prospects for growth.

FAQ

Is invested capital the same as equity?

No, invested capital is treated as the combined value of both equity and debt capital raised by a firm, whereas equity represents the ownership interest of shareholders in a company.

How does the ROIC differ from the ROA and the ROE?

While the ROA and the ROE show a company's profitability relative to its assets and equity, respectively, ROIC specifically focuses on the profit generated on all invested capital, including both equity and debt.