Invested capital is not just a nerdy financial term. In fact, it's a crucial element that directly impacts the health and growth of your business. This podcast, boosting your Financial IQ, is about business financial literacy, strategies for profitability and the principles taught at byfiqcom. My hope is that you'll apply the lessons learned and that we can work together soon in my mastery program. Enjoy the show and don't forget to subscribe. If you're a business owner or someone managing a business, we can work together soon in my mastery program.

In the audience and I was listening to this facilitator talk to the group and he was trying to get everybody to agree with him and to understand the importance of improving profitability. So he started and he's like okay, I have company A and company B and I can't remember the exact numbers to just follow along with me. But he said okay, company A does 5 million in revenue and company B does 1 million in revenue. Which company would you rather own? And everybody's like A. Of course, right, you want the company with more revenue. And he's like okay, what if company A is growing at 20% and company B is growing at 10, 10%, which company would you rather own? And everybody's like company A, you know, has a higher growth rate. And he's like, hey, ebitda for earnings before interest, taxes, depreciation and amortization just a fancy way of saying profit. He's like which company would you rather own? Company A, they make $500,000 a year in profit. Or company B they make a hundred thousand dollars in profit. And everybody's like, well, we'd rather go after A because they make more profit. And he's like, yes, exactly. And I was like wait a minute, I didn't say this, but I was thinking this in my head Like wait a minute.

That's not necessarily true, because there's this idea of invested capital and when I'm looking at businesses, whether I want to invest in them or whether I want to help them to turn around, I always look at their capital base in the entire equation. That's why I believe return on invested capital, or economic profit, is a really good measure to understand the true economics of a company. Let me explain when it comes to return on invested capital, essentially, you're just taking profit after tax net operating profit after tax, to be specific and you're dividing that by invested capital. So invested capital has two components. I'm going to get into that here in just a minute, but before I do I want to go back to that example. If you have two businesses, okay, and let's just say one is earning five hundred thousand dollars in profit, the other one's earning a hundred thousand dollars in profit, but the one that is earning $500,000 in profit, more profit, right, let's say the owner had to invest, you know $50 million into the company to earn that 500 grand. But then, on the other hand, the company that is earning $100,000 a year in profit, let's just say the owner only put in you know, $10,000 to get up and going. Which company would you rather own? And that's the difference, right, because invested capital plays a major part on the economic viability and the valuation of a company. So let's go ahead and jump into invested capital. But I wanted to provide you with that example, because if I look at two businesses, let's just say their profit is exactly the same, but one has a lower invested capital base I may be more inclined to invest in the business with a lower capital requirement, with less capital intensity. I'll explain here, so let's jump in.

What is invested capital? At its core, invested capital refers to the amount of capital that has been put into a business to fund its operations and growth. So essentially, it's the money that's being worked to generate value when we get into the nitty gritty. Invested capital is the sum of two key components. First, net PP&E, which stands for property, plant and equipment, and this includes the long-term physical assets a company uses to run its business. Think about machinery, buildings or even vehicles. These are the assets that a business owner invests in in order to produce goods or services over the long haul. All right, and the reason why we look at net PP&E, not gross, is because we want to account for accumulated depreciation, because you have assets right, and over time they are diminishing in value. They're being depleted, right, they're wearing out and you're going to have to replace them one day. That's why we want to look at the net number of property, plant and equipment, all right. The second component, beyond net PP&E, is working capital. This is the capital a company needs to cover its day-to-day operations, for example, paying their bills, buying inventory, covering payroll and handling other short-term needs.

Working capital ensures that a business has enough liquidity to function smoothly. Mathematically, the equation is current assets minus current liabilities. But the nuance here is, when you're looking at current assets, you have to subtract out excess cash right. So if the business is sitting on a large sum of cash. They just keep accumulating cash that's being recorded in current assets. But you have to exclude the excess cash that amount that's above and beyond what's required just for normal operations. And then, on the liability side, you have to subtract out any interest bearing debt. So if you have debt in there where you're paying principal and interest on a monthly basis, you want to exclude that from your working capital formula, right? So in other words, working capital is current assets minus current liabilities. Just make sure you remove excess cash from current assets and remove interest bearing debt from current liabilities, and then that formula will give you your working capital base. So you have net PP&E and working capital. Essentially, it's the amount of capital that's required to run a business and to produce operating profit. So when you combine these two elements, you get a clear picture of how capital has been invested in a company to keep everything running, both in the long term and day to day.

So why is invested capital important? I illustrated that at the beginning with my example with company A and company B. But you may be thinking okay, that's cool, but why should I care about invested capital? Here's why it's crucial for your business, above and beyond what I explained earlier. Number one it measures efficiency. Understanding your invested capital helps you to gauge how efficiently your business is using the money you've put in. So if you're generating high profits but have a lot of invested capital tied up in assets that aren't bringing in much, you might need to rethink how you're allocating resources. It's all about balancing risk with reward. So that goes back to my company A and company B example. Company A you put in $50 million into the business and you're only generating $500,000 in profit. All right, that's gonna take you a long time to pay back your original investment. Versus company B, you only put 10 grand in and you're earning $100,000 in profit. So that's what I'm talking about when I refer to measuring efficiency.

Okay, second, invested capital is important because it could serve as a performance measure. The higher your invested capital, the more money you have tied up in your operations. But the key question is are you getting the returns you expect from that investment? If not, it might be time to evaluate what's working and what isn't. That's where strategy comes into play, because, think about it If you have a million dollars invested in your business but you're only earning $10,000 a year in profit, that's a 1% return, right? That's terrible. You could just take your money and go invest it in a CD or a money market account. So understanding your invested capital base in comparison to your profit is really important, and it'll tell you what your actual return on invested capital is. All right. Third.

The third reason why invested capital is important is because, as a business owner or as a P&L leader, you're always faced with tough decisions on where to allocate your resources. That's what strategy is all about. It's about focusing on the constraints in your business and then allocating resources disproportionately to solve those constraints. So, for example, you may be wondering should you invest in new equipment, expand your team or increase working capital to better manage cash flow? Tracking your invested capital lets you make better informed decisions about the best places to deploy your resources for growth and solving those constraints. To deploy your resources for growth and solving those constraints.

Number four invested capital is important because, if you're looking to expand, having a solid understanding of your invested capital gives potential investors and lenders confidence in your financial health. It shows them that you're actively managing how money is being put to work in your business. It also lets them see how effectively you use capital to drive growth. Years ago, I was working with a company and I computed their invested capital and I found that is about 25% of their revenue, which is big. And so if the business grew by a million dollars, for every million dollars they grew in top line sales, they would need 25% of that for working capital, or $250,000 in revenue. And this business owner is very ambitious and he wanted to like 10X the company and has like, if you 10X the business and you don't have capital coming in from either debt or equity providers to plug the hole, you're gonna grow yourself out of business. So that's why it's really important to understand what your invested capital base is and if you have the resources to fund your growth before you just start growing, because if you dump the gasoline on your business to accelerate growth and you don't understand this concept, like I said, you could grow yourself out of business.

So why should you care? Let's get into this. If you're a business owner or if you're a P&L leader, you should care about invested capital because it directly impacts your bottom line. The way you manage and allocate your invested capital determines how well your company can thrive, grow and sustain itself over time. Without proper management of invested capital, you might find yourself stretched thin or unable to fund opportunities or, even worse, lacking the liquidity to keep the lights on. 70% of companies, remember, that go bankrupt are profitable. When they close their doors, they just run out of cash, and that's what I'm talking about here.

So here's the thing. It's not just about tracking these numbers for the sake of it. It's about leveraging invested capital to increase profitability and ensure you're getting the most out of every dollar spent or invested in your business. If you can optimize the use of your capital, whether through smarter investments in PP&E or efficient working capital management, you can boost your margins and grow your business without unnecessarily taking on debt or diluting equity.

So, as you can see, invested capital is not just a nerdy financial term. In fact, it's a crucial element that directly impacts the health and growth of your business. So, whether you're deciding on a new investment, expanding operations or just simply managing day-to-day cashflow, knowing how much capital is invested in your business and how it's being used helps guide your decisions and shape your strategy for success. Remember, when you can combine strategy and finance together, that's when you generate a ton of value. Right, if you found this valuable, it'd mean the world to me If you shared it with your friend group, with your audience, with your coworkers, whoever it is that you interact with, and if you ever need help with implementing this in your business, you can reach out to me and my team at coltivar. com. All right, all the best, cheers.