Invested capital is the total amount of cash invested in a company since it started operations. In other words, it is capital provided by all investors—both stockholders and debtholders. It is also an important metric of financial performance in value-based management and used in other measurements, such as return on invested capital (ROIC), economic value added (EVA), and free cash flow (FCF).
Invested capital can be calculated in two ways, and both lead to the same result.
The so-called financing approach considers the following formula:
The operating approach involves the following steps:
Both financial and operating approaches assume that the total assets of a company disclosed in a balance sheet need to be adjusted. The reason is that capital leases are disclosed in a balance sheet, but operating leases are off-balance sheet items. So we need to add the present value of expected operating lease obligations to get the correct appraisal of invested capital.
Noninterest-bearing current liabilities or NIBCLs must also be excluded from the invested capital. Common examples of such items are as follows:
- Accounts payable
- Accrual liabilities
- Accrued expenses
- Accrued taxes payable
- Advances received
- Deferred income
- Other accounts payable
- Payroll taxes, social security, and VAT
- Subsidies and deferred revenues
- Trade accounts payable
- Trade liabilities
- Trade payables
In most cases, the approaches above give an accurate appraisal of invested capital, but in some special cases, some extra adjustments are needed to offset accounting distortion in financial statements.
Off-balance sheet reserves. The amount of such reserves should be added up. The allowance for doubtful accounts is an example of such reserves because it doesn’t mean that a company will surely get less cash.
Off-balance sheet assets. Not all assets are disclosed on the balance sheet of a company, e.g., the operating lease is the most common source of off-balance sheet financing because such assets are kept on the lessor’s balance sheet. That is why they should be added up as the present value of all expected lease obligations.
Discontinued operations assets. Such assets are usually disclosed as a separate item on a balance sheet. Because they are not used in operation and don’t generate economic profit, we should remove them from invested capital.
Other comprehensive income. We need to remove the accumulated amount of other comprehensive income because it is not used in generating economic profit and hasn’t been recognized yet in the income statement.
Assets write-downs. A company may recourse to assets write-downs when their fair value drops significantly below their book value. The difference is charged against company income. That leads to a reduction in invested capital value, so if write-downs occur, their after-tax value should be added up.
Deferred compensation assets. Such assets, if available, should be removed because they are not used in generating economic profit.
Deferred tax assets and liabilities. Deferred tax assets and liabilities mostly arise due to differences in tax policy and accounting standards. Deferred tax assets occur when income reported in financial statements is less than taxable income. In contrast, deferred tax liabilities occur when income reported in financial statements is greater than taxable income. Deferred tax assets increase the total assets value but don’t generate economic profit, so they should be removed. In turn, deferred tax liabilities are the expected amount of taxes to be paid in the future, so they can be classified as noninterest-bearing liability and should be also removed from invested capital.
Invested capital calculation example
XYZ Company announced the balance sheet for the last year.
US $ in thousands
Some part of the company’s machinery is used under an operating lease agreement, which will be valid for another 5 years. The lease payments in the next 5 years are expected to be as follows:
- at the end of 1st year $2,350K
- at the end of 2nd year $2,550K
- at the end of 3rd year $2,600K
- at the end of 4th year $2,800K
- at the end of 5th year $2,750K
The WACC of XYZ Company is 14.85%.
To get the final amount of invested capital, we will use the operating approach mentioned above.
A company has the following items in a balance sheet recognized as NIBCLs: accounts payable, accrual liabilities, advances received, and accrued taxes payable.
NIBCLs = 5,680 + 1,890 + 1,770 + 1,230 = $10,570K
To get an appraisal of off-balance sheet assets, we need to calculate the present value (PV) of expected operating lease obligations.
At least we need to make an adjustment; namely, remove deferred tax liabilities of $40K, so the amount of invested capital of XYZ Company is $48,061.08K.
Return on invested capital, ROIC
The value of invested capital is also used to calculate ROIC.
where NOPAT is net operating profit after taxes (to calculate it, please follow these guidelines).