The capacity of a business to produce goods and services is determined by the amount of capital it has invested in the tools, machinery, buildings and other assets required for its operations. When the owners add to the capital invested by reinvesting profits or by procuring more money from investors, it creates the opportunity to increase the productive capacity of the business. That is, an increase in net investment makes it possible for the business to expand its operations and grow its revenues.
Net Investment and Gross Investment
The total amount of capital a business invests in its operations is generally referred to as the gross investment. However, the value of many types of assets declines over time as they age or become obsolete. This decrease in value is called depreciation. Production equipment, vehicles and buildings are examples of assets that depreciate. Not all capital assets depreciate. For example, land owned by a business can hold its value and may even appreciate. Net investment takes depreciation into account, so it is is a more accurate measure of the amount a business is investing in itself than gross investment.
The Importance of Net Investment
Sometimes a business has a bad year and loses money. The owners may have to scale back or even suspend purchases of capital assets. Depreciation can cause the overall value of the business to decline, resulting in a negative net investment. This decline can be reversed if the firm's fortunes improve, so a short-term loss of value due to depreciation isn't necessarily a threat to the company's viability. However, if the lack of investment capital persists, it can lead to major problems. Buildings and equipment age and require more maintenance. Production machinery may become less productive or obsolete. Over time, the business will become less competitive. In general, a business needs to invest at least enough money to offset depreciation.
Before you can calculate net investment, you have to know the amount of depreciation that occurred during the previous accounting period. Suppose the firm purchased equipment for $500,000 that has an expected useful life of 15 years and a projected residual value of $50,000. To figure the amount of depreciation using the straight-line method, first subtract the residual value from the $500,000 purchase price, leaving $450,000. Divide by 15 years to figure the depreciation amount of $30,000 per year.
Calculation of Net Investment
Once you have computed the depreciation for each capital asset, add up the amounts and subtract the total from the gross investment for the period. For example, if the total depreciation allowances come to $100,000 and the business had a gross investment of $500,000, the net investment equals $500,000 minus $100,0000, or $400,000.