A lot goes into a business—blood, sweat and usually a bucket load of capital.
But how much money do you need to invest in your business to turn a profit? Are you already seeing a return on your investment? And if not, how much must your business generate to be considered a profitable investment?
Every business owner wants to ensure their business is performing well. Performance is important when comparing your business to others in the industry or if you are looking to see if a business would make a worthwhile merger or acquisition.
One key aspect of business performance is invested capital.
Measuring invested capital provides valuable insights into a business’s efficiency, profitability, and overall financial health.
Delve into what invested capital is, how to calculate it, and why it is so important for the success of small to medium businesses.
What is Invested Capital?
Invested capital is the total amount of money a business has used to commence the core functions. This would be the costs of its operations, assets, and other productive ventures.
For example, a mobile coffee truck would incur upfront costs of the vehicle, the actual coffee machines, fridges and fixtures inside the truck/van, and the cups and ingredients.
Invested capital includes both equity and debt financing. This is the total value from the owner and any bank or creditors’ financial commitment to the business.
This capital is utilised to acquire assets like a fancy milk frother, finance daily operations such as paying barista wages or petrol, and drive growth initiatives. In the example of the coffee truck, this could mean replacing the coffee machine with a new model with more options or getting the truck wrapped in company branding.
How to Calculate Invested Capital
To know if your business has turned a profit on the invested capital, you first need to calculate exactly how much has been invested into the business. Calculating invested capital involves a straightforward formula. To determine it, follow these steps:
Step 1: Identify Total Debt
Add up all the long-term and short-term debts owed by the business, including loans, bonds, and other liabilities, which can be easily found on your balance sheet.
Step 2: Determine Total Equity
Sum up the owner’s equity. This includes what you, as the business owner, have paid into the business, known as ‘common stock’, any amounts invested by a third party such as a bank or partner called ‘preferred stock’, and retained earnings. Retained earnings refers to the business’s profits over time.
Imagine you partner with a friend to open a restaurant.
You have invested $5,000 of your own money (common stock), and your friend invested $3,000 (preferred stock).
Over the months, your restaurant has earned $1200 in profit that you didn’t spend (retained earnings).
To calculate the owner’s equity, you would add up $5,000 (your investment) + $3,000 (your friend’s investment) + $1,200 (earned profit) = $9,200.
So, your owner’s equity is $9,200, which represents how much of the restaurant’s value belongs to you and your friend.
Equity can be found on a company’s balance sheet and is one of the most common pieces of data to assess a company’s financial health.
Step 3: Add Debt and Equity
Combine the total debt and total equity calculated in steps 1 and 2.
Step 4: Subtract Non-Operating Assets
Exclude non-operating assets, such as surplus cash, marketable securities, stocks, bonds, and mutual funds. These securities are listed as assets on a company’s balance sheet because they can be easily converted into cash. Further, deduct any investments not directly related to the core business operations.
The result represents the invested capital of your business.
But simply knowing how much you have invested into your business does not provide a comprehensive view of business performance.
The next step is to calculate if your business is providing you a return on your investment and how much it is.
Calculating Return on Invested Capital (ROIC)
ROIC is an essential financial metric that measures the efficiency with which a company generates profits from its invested capital.
It indicates how well the business utilises its capital to produce earnings. Invaluable information if you are looking into a merger or acquisition.
ROIC is always calculated as a percentage. A higher ROIC signifies effective capital deployment and superior financial performance.
Calculate ROIC using the following formula:
ROIC = Net Operating Profit After Taxes (NOPAT) / Invested Capital
Step 1: Calculate NOPAT
Net Operating Profit After Taxes (NOPAT) is the profit generated from core operations after deducting taxes.
NOPAT=Operating Income×(1−Tax Rate)
Operating Income is the income derived from a company’s primary or core business operations minus its core expenses.
If the coffee truck had a partner selling baked goods on the side, then the operating profit would be from making the coffee alone. Not including any interest or earnings from rent/commission from the baked goods. And minus the operating expenses.
Once the tax is deducted from the operating income (as in the equation above) equals NOPAT. A business would have earned this if it had no debt or bills to pay. It is a more accurate measure of pure operating efficiency.
Step 2: Calculate ROIC
Divide the NOPAT obtained in Step 1 by the invested capital to get the ROIC.
Companies with a steady or improving return on capital will unlikely need new capital to work. For example, start your own business with the $10,000 from your own pocket. Your business has grown, and you recorded operating income at $25000 whilst being taxed 30%.
NOPAT = $25,000 (operating income) x (1-0.3, which is the tax in decimal form) = $17,500
ROIC = $17,500 (NOPAT) / $10,000 (original investment) = 1.75, which is a 175% return for the year.
The return on invested capital can be used as a benchmark to calculate the value of other companies as well. Some firms run at a zero-return level, and while they may not be destroying value, these companies have no excess capital to invest in future growth.
Why is Measuring ROI Important?
Measuring Return on Invested Capital (ROIC) is important for several reasons:
Efficiency Assessment:
ROIC is a barometer to gauge how well the company utilises its invested capital to generate profits. A higher ROIC suggests optimal capital allocation and operational efficiency.
Performance Benchmarking:
Comparing ROIC with industry peers helps business owners understand how their company fares against the competition. It offers insights into areas that require improvement for better performance.
Investment Decision-making:
When considering potential investment opportunities or expansion projects, ROIC helps evaluate their potential returns. It aids in identifying ventures that can maximise shareholder value.
Risk Analysis:
ROIC also assists in assessing the risk associated with the business. A declining ROIC might indicate operational inefficiencies or financial distress, warranting immediate attention.
Shareholder Confidence:
A strong ROIC can boost investor confidence and attract new investors as they are particularly interested in a company’s ROIC, indicating the company’s ability to generate a return on its investments.
Strategic Planning:
ROIC insights can guide strategic decision-making, enabling businesses to focus on initiatives that promise higher returns and long-term growth.
Measuring Invested Capital Entices Investors
Measuring capital and ROIC provides valuable insight to owners and investors planning strategic moves in the current climate.
By understanding how efficiently their capital is utilised, business owners can make informed decisions about investing more into their business and attracting investors with a proven record.
Alternatively, calculating the ROIC can identify areas for improvement and help owners implement effective strategies if their business needs restructuring to be self-sufficient. A low ROIC may not deter buyers if they know how to utilise the capital more effectively in a merger or acquisition.
Monitoring these financial metrics empowers businesses to stay competitive, enhance shareholder value, and secure a prosperous future amidst economic challenges.
Elements Advisory Group’s Financial Performance Assessment (FPA) gives you a comprehensive view of how your business is performing financially. A full analysis of the business operations results in a breakdown of key performance indicators to show strengths and weaknesses and areas for improvement.
Contact us today for a clear view of all key performance indicators and how your business compares to current industry markets.
Call us on 07 3878 9181 or email us at admin@elementsag.com.au
