What is Invested Capital?

Invested capital is the funds invested in a business during its life by shareholders, bond holders, and lenders. This can include non-cash assets contributed by shareholders, such as the value of a building contributed by a shareholder in exchange for shares or the value of services rendered in exchange for shares.

Understanding Invested Capital

A business must earn a return on its invested capital that exceeds the cost of that capital; otherwise, the company is gradually destroying the capital invested in it. To do so, it must earn a relatively high return on invested capital in the form of equity, since investors demand the highest return on this form of capital. It can earn a lower return on invested capital in the form of debt, since investors generally expect a lower return for this form of financing. However, it must generate a positive return net of the cost of its invested capital, or else it will not earn an economic profit.

Calculation of Invested Capital

The amount of invested capital is not listed on a company's balance sheet as a separate line item. Instead, the amount must be inferred from other information stated in a company's accounting records. The calculation for invested capital under the financing approach is:

+ Amount paid for shares issued
+ Amount paid by bond holders for bonds issued
+ Other funds loaned by lenders
+ Lease obligations
- Cash and investments not needed to support operations
= Invested capital

Retained earnings (earnings generated by a business) are not included in the calculation of invested capital.

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An alternative way to derive invested capital is called the operating approach. Under the operating approach, the calculation of invested capital is as follows:

+ Net working capital needed for operations
+ Fixed assets net of accumulated depreciation
+ Other assets needed for operations
= Invested capital

The problem with either variation on the formula is that the determination of how much cash and other assets are needed to support operations is a judgment call, and so can vary based on the perceptions of the person creating the measurement. Usually, a lengthy cash conversion cycle calls for the designation of more assets as being necessary for operations.

Presentation of Invested Capital

The total amount of invested capital is not listed in one place on a company’s balance sheet. Instead, it is scattered among several accounts, including the debt obligation, lease obligation, and shareholders’ equity line items.