Emerging Practices for Capital Adequacy © Copyright 2003, CCRO. All rights reserved. 10 II. DETERMINING NET ASSETS FOR ECONOMIC VALUE Capital adequacy for economic value is the difference between “net assets” and the sum of “debt” and “economic capital”: Capital Adequacy = Net Assets1 – (Debt + Economic Capital) There are two alternatives for measuring net assets: invested capital and market value. Invested capital uses accounting data and measures assets, liabilities, and equity according to Generally Accepted Accounting Principles and Financial Accounting Standards Board pronouncements such as FAS 133 this paper does not address accounting or GAAP issues, which were considered out of scope. Companies should be aware that these issues exist, however, and discuss them with the controller and internal auditor. The second alternative, market value, uses economic data and appraises assets, liabilities, and equity with financial models driven by current market-based information. These alternatives have inherent advantages and disadvantages that should be taken into account when deciding which alternative to use to measure net assets. 2.1 Alternative 1: Net Assets Based on Invested Capital Invested capital is the total capital invested in the company by all capital providers. While invested capital can be calculated from either the asset or liability side of the balance sheet, this discussion examines it from the asset side. Both long-term and short-term assets and items such as fixed payments and net plant and equipment should all be included as components of invested capital. For a trading business, not only should such items as cash and net accounts receivable be included, but also collateral and margin requirements. The value of these assets is the accounting or book value as depicted on the balance sheet. Figure 6 illustrates the tree of all components of invested capital typically included in an analysis. 1 Since equity is equivalent to net assets minus debt, determinations of debt/equity ratios that affect credit ratings should be considered in light of the risks a business is assuming.