Working Capital vs Investing Capital – Overview and Differences
Capital is an important component of every business, no business can launch, grow, and thrive without adequate capital. While the definition of capital is pretty straightforward for the layman, financial analysts and business owners are required to distinguish between two different types of capital: working capital and investing capital.
Proper management of working capital and investing capital is essential to a company's financial health and operational success. In this article, we are going to look at the differences between working capital and investing capital and how to calculate return on invested capital.
Let’s get started.
What is Working Capital?
Working capital is defined as the total amount required by a company to control or manage its operation. It shows the capacity of a company to use current assets to pay its current liabilities. This shows the efficiency and ability of debt payment by the company annually.
The working capital shows:
1. Current Assets
Current assets are assets that can be in the form of raw materials, cash, and products that must be used or sold by a company in a year. They are to be sold, consumed, or changed into cash within a year or operating cycle.
Other forms a current asset can take are finished goods, unfinished goods, cash, money in bank accounts, bonds, accounts receivable, checks, or prepaid expenses.
Current assets are used to pay up current liabilities. To calculate current assets, you add the cash in hand and other assets together.
2. Current Liabilities
Current liabilities are obligations or debts owed by a company and must be paid within a year or normal operating cycle. Examples of these debts are rents, payment for services rendered, accounts payable, interests, accrued taxes, and short-term debts.
They are also known as short-term liabilities. Current liabilities are usually cleared by current assets.
How to Calculate Working Capital
To calculate working capital, the current assets are divided by the current liabilities. This is known as the current ratio. If the current ratio is above 1, then the current assets are more than the current liabilities but if it is lower than 1, the current liabilities are more than the current assets. It is however advisable that the ratio is higher.
A higher ratio means the company can easily fund its operation without running into debts or eventually going bankrupt. Also, a ratio less than 1 means the company does not have the financial means to settle its debts and it is therefore considered risky.
What is Investing Capital?
Investing capital is the amount of money or physical asset provided for expanding or effective running of a business or company. It is also known as capital investment.
Capital investments provided from different sources like individuals, executives, investors, or financial institutions are what forms investing capital. It is used to generate revenue or create expansion in the market.
There are two cases in which capital investment works.
- Physical Capital Investment: In this case, the investment is made by buying long-term assets. The decision is made by the company's management.
- Financial Capital Investment: This involves the investment of a large amount of money in the company by angel investors, individuals or banking institutions. The investment can be done before or after the establishment of the business.
The benefits of acquiring investing capital are increased growth of the business, source of revenue, job opportunities, and more market competition for both the customers and producers.
Working Capital vs Investing Capital: What are the Differences?
The difference between working capital and investing capital can first be found in their definitions. Working capital is the financial assets of a business and is used for short-term financing while investment capital is the procurement of money by a business or company to buy non-current assets and help achieve other financial goals.
Other differences between working capital and investing capital include:
1. Time Required
The time required to gather working capital is lesser compared to investing capital that requires a large amount of time and processing. Working capital must be acquired urgently to ensure the normal running of the business.
2. Budgeting Process
The budgeting process of the working capital represents the money required to fund the annual operating cash ﬂow while that of the investing capital involves the potential inflow of cash.
The investment of working capital is restricted to a specific timeframe. It is involved with the daily running of the business and it is invested in the current assets of a business.
Meanwhile, the capital investment is based on the long-term running of the business and it is more concerned with the long-term assets of the business.
How to Calculate Return on Invested Capital
Return on Invested Capital (ROIC) is a profitability ratio that reveals how much a company earns from its invested capital, calculated in percentage. This ratio is used to test the company's efficiency by showing how the company makes use of capital to gain profits.
If a company's Return on Invested Capital (ROIC) is more than its weighted average cost of capital (WACC), it means the company has increased in value.
ROIC = NOPAT / Invested Capital
Net Operating profit after tax (NOPAT) is the profit made after making necessary deductions including tax deductions.
Invested capital is the total amount by a business during that period.
The total invested capital of a company is $100,000 while the net profit after tax is $25,000. What is the ROIC of the company?
ROIC = NOPAT / Invested Capital
ROIC = $25,000 / $100,000
ROIC = 0.25
ROIC = (Net Income – Dividend) / (Debt + Equity)
The net income of AZ Deliveries is $15,000 with $30,000 shareholder equity and total debt of $20,000. Calculate the ROIC.
ROIC = (15,000 – 0) / (20,000 + 30,000)
ROIC = (15,000) / (50,000)
ROIC = 0.3
Invested capital is the total sum of money invested in a company or business by stakeholders. It may also include assets that are not in cash.
You can calculate it by using this method.
Invested Capital = Total short-term debt + Total long-term debt + Total lease obligation + Total equity + Total non-operating cash or investments.
Another method of calculating invested capital is the addition of net working capital for operations, net fixed assets of accumulated depreciation, and net intangible (or other assets) needed for operations. This is called the operating method.
Capital investments are made for the long-term running of a business and also to ensure goals are met and achieved. They are also used to purchase fixed assets such as:
Infrastructure: Investing in infrastructure such as roads and bridges gives hope for easy cash flow.
Automobile: Purchasing or vehicles for transportation of goods and services by a company is another way of investing in the company.
Branding: This is the purchase of brands from a company, purchase in form of patents or the company itself.
Computers and Machines: Purchase of computing devices and industrial machinery for the company.
Lands and Properties: Acquiring lands and properties is beneficial due to the increase or appreciation in land value.
Maintenance: This is the extension of the lifespan of machinery, equipment, and facilities through repairs. It is useful in cutting expenses.