Invested capital is the total amount of money raised by a company through the issuance of securities to equity shareholders and debt to bondholders. Return on Invested Capital (ROIC) is a crucial metric used to gauge the company’s efficiency in allocating its capital to profitable activities.
Total debt, along with capital lease obligations, are added to the amount of equity issued to investors. Invested capital isn’t explicitly listed on a company’s financial statements because individual components like debt, capital leases, and stockholders’ equity are reported separately in the balance sheet.
Key Takeaways
- Comprehensive Financing: Invested capital covers the combined value of equity and debt capital, including capital leases.
- Profitability Measure: ROIC is used to measure a firm’s effectiveness in utilizing its capital to generate profits.
- Cost of Capital: A firm’s weighted average cost of capital helps determine the cost of maintaining invested capital.
Understanding Invested Capital
Companies need to generate earnings higher than the cost of capital provided by bondholders, shareholders, and other financing sources to achieve economic profit.
To assess capital efficiency, businesses consider various metrics such as return on invested capital (ROIC), economic value added (EVA), and return on capital employed (ROCE).
For instance, if a company like IBM issues 1,000 shares at $10 par value and sells each for $30, it raises $30,000. The shareholders’ equity section increases the common stock balance by the par value, i.e., $10,000, and the remaining $20,000 boosts the additional paid-in capital account.
If IBM also issues $50,000 in corporate bonds, the long-term debt section of the balance sheet rises by $50,000. In total, IBM’s capitalization increases by $80,000.
How Firms Earn a Return on Capital
Successful companies maximize the return on the capital they raise. For example, if a plumbing company issues $60,000 in additional shares to purchase new trucks and equipment, it can perform more residential work, increasing earnings and potentially paying dividends to shareholders.
Dividends enhance each investor’s return on stock, while increased earnings and sales can drive stock price appreciation. Businesses might repurchase previously issued shares, reducing the number of outstanding shares and, consequently, increasing earnings per share (EPS).
Return on Invested Capital (ROIC)
ROIC is essential for evaluating a company’s efficiency in using capital under its control. It’s calculated as a percentage, usually on an annualized or trailing 12-month basis, and compared with the weighted average cost of capital (WACC) to determine value creation.
A common benchmark for value creation is a return exceeding 2% of the firm’s cost of capital. ROIC above this threshold indicates value creation and typically leads to premium stock trading. Conversely, ROIC below 2% suggests value destruction.
Calculation and Examples
How Do You Calculate Capital Invested?
Capital Invested = Total Equity + Total Debt (including capital leases) + Non-Operating Cash.
What Is an Example of Capital Invested?
For instance, if a private company goes public via an initial public offering and sells one million shares to raise $17 million, that constitutes invested capital. Similarly, issuing $10 million worth of bonds at a 3% coupon rate is another form of invested capital.
What Is a Good Return on Invested Capital?
A satisfactory return on invested capital (ROIC) is 2% and above. Firms with an ROIC below 2% are viewed as destroying capital.
The Bottom Line
Invested capital represents the money a company raises through equity and debt financing, either to grow or maintain operations. Properly managing this capital is crucial for sustaining profitability and driving long-term business growth.
Related Terms: Equity Shareholders, Debt Bondholders, Capital Leases, Economic Profit, WACC, Earnings Per Share.
