Net Investment Definition
Net investment is the net amount invested by the company on its capital assets, which is calculated as the capital expenditure for the period less non-cash depreciation and amortization for the period, and it indicates how much is the company investing in maintaining the life of its assets and attaining future growth in the business.
Net Investment Explained
Every business, big or small, uses assets to generate revenues and earn profits. These assets go through wear and tear in the normal course of business. The assets essentially lose their useful life, and to maintain the business as a going concern, the assets base has to replenished by investing capital on them. Net investment is an amount the company spends over and above the depreciation on acquiring new assets or maintaining existing assets.
Net investment requirement varies from business to business. For example, a service-based business, which generates all of its business from its workforce, may not require much investment to grow because its major cost will be salaries, which are Opex. On the other hand, a business that generates considerable business from manufacturing or using an intellectual property may have to keep investing in assets for sustainable growth.
Net Investment Formula
Net investment formula is represented as below:
- Capital Expenditure is the gross amount spent on maintenance of existing assets and acquisition of new assets
- Non-cash depreciation and amortization is the depreciation and amortization expenses shown on the income statement.
Examples of Net Investment Calculation
Below are examples of net investment calculation
Let’s assume a company spent $100,000 in capital expenditure in a year and has a depreciation expense of $50,000 on the income statement.
Calculation of Net Investment
Its net investment in this case is $50,000 ($100,000 – $50,000).
Net investment can be understood much better by studying a real-world example of Netflix Inc., the popular video streaming service. Netflix’s business model involves investing in video content by creating shows and movie content of its own and buying streaming rights of other organizations’ content and selling the viewing rights to its huge 150 million subscriber base worldwide.
Netflix has to keep investing in content to maintain a library of content to ensure continuity of payments from its subscribers. If Netflix’s content becomes outdated, and there is nothing new to watch, its subscribers will log-out of Netflix to never come back.
Here is a snapshot of how much Netflix invested in its content in 2018
The company added more than $13 billion in content assets and amortized more than $7.5 billion in content assets. Using this information Netflix’s net investment can be calculated as shown in the below table:
Calculation of Net Investment
The company has a net investment of $5.5 billion.
Note: While Netflix considers the cash flow from these activities as operating, they are certainly investing cash flows as the benefits of the content rights accrue over a long period of time.
Importance of Net Investment
As stated earlier, any company would need to invest in its assets to maintain its growth and to avoid getting obsolete somewhere down the line.
What would happen if the company keeps on sweating its assets and does not invest in new assets? The older asset base will definitely get outdated, inefficient, and will frequently break down. Given this, the company’s production and sales will be impacted and will lead to demand exhaustion, customer dissatisfaction, product returns, and the ultimate demise of the corporation.
For avoiding the demise, managements keep on investing in their company’s existing assets and new assets. Investment in existing assets helps the company retain the level of sales and profits while investment in newer assets could be to keep pace with the new technologies or to create a different source of revenue and profits if the existing business is expected to get obsolete in the future.
Difference between Gross Investment and Net Investment
Gross investment is the company’s capital investment without deducting depreciation. It tells us the absolute investment the company has made in its assets in a particular year. Though the number in itself is valuable, it is helpful to analyze after netting it to determine if the company is only investing in retaining its current business or is also investing in the future.
- Net investment indicates the replacement rate of the company’s assets
- Net investment (if positive), generally helps the company remain in business
- It gives a fair idea to the analysts and investors to understand how serious the company is about its business and shareholders
- It tells us about the capital intensive the business (capital intensive businesses guzzle a lot of capital)
The business world is dynamic, and it changes pretty rapidly. Today’s hot product may not even exist tomorrow if it is not adequately nurtured. Managements can not choose to ignore investing in the betterment of their existing businesses and create additional products to increase their sources of revenue.
Take CD/DVD business. For example, the business is dead because of the shift of the video market from CD/DVD to online streaming and the shift of the storage market to portable storage devices. The companies which did not invest in these newer technologies at the right time are now out of business.
One should approach investment in a strategic manner. As a general rule, if the company is investing only as much as it is depreciating, it may be a problem. However, this may not hold true for all businesses. Some business models do not require too much investment and can go on for a long time just by maintaining their brand value. Such businesses have lesser capital expenditure requirements, and they can come out with newer products with minuscule investment in research and development. Understanding the strategic requirement of net investment in a business is the key to analyzing the future prospects of the company.
This has been a guide to Net Investment and its definition. Here we discuss a formula to calculate net investment along with examples, importance, and differences with gross investment. You can learn more about investments from the following articles –