Show pageOld revisionsBacklinksBack to top This page is read only. You can view the source, but not change it. Ask your administrator if you think this is wrong. ======Invested Capital====== Invested Capital (also known as 'Capital Employed') is the total pool of money a company has used to finance its operations and build its assets. Think of it as the total funding provided by both shareholders and debtholders that management has at its disposal to generate profits. It represents every euro or dollar that has been "invested" in the business, from the machinery on the factory floor to the inventory in the warehouse. For a [[Value Investing|value investor]], this figure is not just an accounting line item; it's the fundamental measure of the capital engine that drives the business. Understanding how much capital a company uses is the first step toward figuring out how //effectively// it uses that capital, which is the true secret to identifying wonderful businesses. ===== Why Does Invested Capital Matter to a Value Investor? ===== Imagine you give two chefs the same amount of money to open a restaurant. Chef A builds a thriving eatery that makes a huge profit, while Chef B barely breaks even. You'd rightly conclude that Chef A is the better operator. Invested Capital is that initial sum of money. A company's management team are the chefs, and their primary job is to generate the highest possible profit, or [[Free Cash Flow]], from that capital. The most powerful metric derived from this concept is the [[Return on Invested Capital (ROIC)]]. This ratio (ROIC = Net Operating Profit After Tax / Invested Capital) tells you exactly how much profit the company generates for every dollar of capital invested in the business. A company that consistently earns a high ROIC (say, over 15%) is likely a high-quality business with a strong [[Competitive Moat]]. It's a sign of a skilled "chef" who can turn capital into exceptional profits. This is the holy grail for value investors like [[Warren Buffett]], who seek to own wonderful companies at fair prices. ===== How to Calculate Invested Capital ===== There are two primary ways to calculate Invested Capital, both using figures from the company's [[Balance Sheet]]. While they look different, they are two sides of the same coin and should theoretically produce a very similar number. ==== The Financing Approach (Where the money came from) ==== This method adds up all the capital sources. **Formula:** Invested Capital = [[Total Debt]] + [[Total Equity]] - Non-Operating Cash * **Total Debt:** This includes all interest-bearing borrowings, both short-term and long-term. It's the money loaned to the company. * **Total Equity:** This is the money invested by the owners (shareholders), including [[Retained Earnings]]. * **Non-Operating Cash:** We subtract any cash and cash equivalents that are //not// essential for the company's day-to-day operations. Why? Because this excess cash isn't being "employed" to run the business; it could be paid out to shareholders as a [[dividend]] tomorrow without impacting the company's earning power. ==== The Operating Approach (Where the money is used) ==== This method adds up all the assets the capital was used to buy. **Formula:** Invested Capital = [[Net Working Capital]] + [[Property, Plant, and Equipment (PP&E)]] * **Net Working Capital (NWC):** Calculated as non-cash [[Current Assets]] (like inventory and accounts receivable) minus non-debt [[Current Liabilities]] (like accounts payable). This represents the capital tied up in short-term operations. * **Property, Plant, and Equipment (PP&E):** This includes the long-term assets like factories, land, and machinery that are the core of the business's productive capacity. Some analysts also include other long-term assets like [[Goodwill]] and intangibles here (see pitfalls below). ===== A Practical Example ===== Let's look at the simplified balance sheet for a fictional company, "Durable Motors Inc." * **Assets** * Cash: €20 million * Accounts Receivable: €50 million * Inventory: €70 million * PP&E (Net): €300 million * **Total Assets: €440 million** * **Liabilities & Equity** * Accounts Payable: €40 million * Short-term Debt: €30 million * Long-term Debt: €120 million * Total Equity: €250 million * **Total Liabilities & Equity: €440 million** Let's calculate Invested Capital using both methods. Assume all €20m of cash is non-operating excess cash. - **Method 1 (Financing Approach):** * Total Debt (€30m + €120m) + Total Equity (€250m) - Cash (€20m) * = €150m + €250m - €20m = **€380 million** - **Method 2 (Operating Approach):** * Net Working Capital [ (Receivables €50m + Inventory €70m) - Payables €40m ] + PP&E (€300m) * = (€120m - €40m) + €300m * = €80m + €300m = **€380 million** As you can see, both paths lead to the same destination: Durable Motors Inc. employs €380 million of capital in its business. ===== Common Pitfalls and Nuances ===== ==== What About Goodwill? ==== Goodwill is an intangible asset created when one company acquires another for a price higher than the fair market value of its assets. Some investors, including Warren Buffett, argue that you should //include// Goodwill in Invested Capital. Their logic is that it represents a real cash outlay the company made, and management must earn a return on that acquisition cost. Others prefer to //exclude// it to measure the return on just the tangible, productive assets. There is no single right answer, but it's crucial to be consistent in your approach. ==== Operating Leases ==== Historically, companies could keep certain lease obligations off their balance sheets. Recent accounting changes (like IFRS 16 and ASC 842) now require companies to report [[Operating Leases]] as both assets and liabilities. For accuracy, these lease liabilities should be treated as a form of debt and included in the Invested Capital calculation. ==== It's a Snapshot in Time ==== The Balance Sheet only shows a company's financial position on a single day. A company's capital can fluctuate, especially if it's seasonal. To get a more representative figure for calculating ROIC, it is often better to use an **average Invested Capital** over a period (e.g., (Beginning of Year IC + End of Year IC) / 2).