The term investment base shows up most often in three financial contexts: sales of receivables, capital structuring, and valuations. In a sentence, investment base is an umbrella term used to reference the valuable portion, or net portion, of a pool of assets and liabilities.
The reason we use the term “investment base” rather than “available assets,” is to avoid confusion when in contexts where the words “asset” and “liability” represent many ideas. After all, the sale of receivables, capital structuring, and valuations are all exchanges in which we repeat those words. By identifying an investment base as the net value of assets, we bring clarity to discussions.
This article will outline the three most common definitions of investment base and explore them with examples.
Three Definitions of Investment Base
Here are the three most common definitions of investment base, all of which fall into contexts where there is an exchange or valuation of underlying assets.
- Sale of receivables. In the sale of creditor receivables from one institution to another, investment base is calculated as the eligible receivables minus the reserves related thereto, plus delinquent receivables considered as bad debt.
- Capital structuring. Company assets are funded with equity and liabilities. In the context of valuing those assets, our investment base is the total of equity and liability accounts that produce usable funds, or the total of long term assets plus cash. An “unusable” asset example is accounts receivable, which is “unusable” until it is paid and becomes cash.
- Valuations. Valuations determine the fair market value (FMV) of assets identified as either collateral for a loan or for the purpose of equity purchases. Our investment base in these cases is the book value of assets, calculated as [asset value] – [accumulated depreciation]. It’s important to note that we most often analyze a group of assets rather than a single one. Groups of assets on the balance sheet undergo swings over time as they are bought and sold.
What does base investment mean?
The difference between investment base and a similar term, base investment, is that the former refers to receivable sales, capital structuring, and valuations, whereas the latter refers to any initial contribution to an investment security or project.
Base investment is a general term that encompasses any contribution at the start of a project, whereas additional contributions to the same project at a period after the start would be called additional investments or additional contributions.
Synonyms for base investment include outlay, up-front investment, start-up investment, and kickoff investment.
Sale of Receivables: Investment Base Example
Selling receivables is common in debt institutions such as banks and collections agencies. But for those who aren’t familiar, it can be difficult to conceptualize. Let’s look at an example of an apartment receivables owner who sells the receivable to a collections agency.
Imagine LHOFT apartments runs an outlet of rooms that rent for $500 per month in upstate Georgia. One of its tenants, Jimmy, refuses to pay his last month of rent, claiming that LHOFT did not clean the room regularly as was agreed in the contract.
The LHOFT thus has a receivable on its balance sheet of $500. However, since the tenant has said he will not pay, the LHOFT only has two options. Either they consult an attorney and go to court with Jimmy, or they sell the obligation to a collections agency at a discounted price. They decide to sell the receivable.
The nuance here is that this receivable must be considered “Eligible.” This simply means that the LHOFT does not have any further service to provide in order to have the right to the receivable. Since Jimmy has already left the apartment and is not still living there, the receivable is Eligible.
But this receivable is not the final amount. The LHOFT must first inform Jimmy that they will sell his debt to an agency and allow him to pay a portion or all of the debt before this time. Jimmy decides he will pay $100 of the $500 debt since this is what he can afford.
Now the LHOFT must re-qualify it’s agreement with the collections agency by subtracting Jimmy’s payment from the debt owed, coming to a net obligation of $400. This is the investment base.
In other words, the formula for a true Eligible receivable is [Eligible receivable] – [reserves held with respect thereto]. But this is not the last step. When the LHOFT sells the debt, they must provide the collections agency with a margin. To do so, they sell the debt for $300. This means when the collections agency earns the $400, they earn $100 in profit. At the same time, the LHOFT only loses $200 in total, rather than $500.
It’s important to remember that the dynamic between Eligible receivables, reserves, and delinquent receivables changes. For example, if an insurance company delivers coverage, but has a receivable with a client with regular payments, the regular payment applicable before the sale of the receivable must be subtracted from the Eligible sum. In other words, the true nature of an investment base of sold receivables depends on the business situation.
Capital Structure: Investment Base Example
The term investment base in a corporate setting refers to the composition of equity and debt as sources of funds for usable assets, i.e those that are liquid. You can envision a company’s investment base of assets with the following visualization:
This is a classic graphical explanation of an investment base, also known as a capital structure. In this example, the structure is 70% equity and 30% debt. Depending on the industry, this composition is more or less advantageous.
Generally, it’s best to have a company with enough profits to pay the entirety of operations, meaning the equity is huge. However, some industries necessitate the use of debt instruments to generate cash for growth. By taking on debt, companies can attack new markets and generate more cash.
This dynamic implies that the investment base in a growing company may swing over time. The reason we refer to this as an investment base is because investors are interested in how much debt the company can use to leverage their equity and pay out even more money in dividends.
The important nuance to remember here is that investment base refers only to the portion of equity and debt that fund “usable” assets. Accounts receivable is not usable, because it awaits cash inflow, whereas big plant and land assets can be liquidated quickly.
Valuations: Investment Base Example
In the world of acquisitions, the concept of an investment base refers to the net value of all assets after accumulated depreciation is taken into account. Imagine you own an electricity company that puts up electrical wires around the city of Sparksville.
Over the course of 5 years you have constructed 1 million USD worth of electrical plants, and you own them. The assets on your balance sheet are thus worth 1 million USD, and they depreciate by 10% years.
This setup means that after 5 years, 50% of the assets are depreciated. As you depreciate them, they loose their value. This means that if the company must be evaluated based on its assets, you only have 500k USD after 5 years. This is called book value, and is your investment base for the valuation.
At the same time, many argue that this kind of investment base does not represent the true value of the assets. Instead, they would argue that the value of the company is not the accounting, investment base value, but rather the performance of the company. In the later, cash flows and EBITDA should be the basis for evaluation.
Investment Base for the CMA Examination
The Certified Management Accreditation (CMA) examination is a highly sought after title for finance professionals working within companies. One of the key terms on the exam is Investment Base. But which of our three definitions should you prefer for this exam?
Since the CMA is an exam for corporate finance professionals, we should prefer definition two, which concerns capital structuring. In other words, when you see investment base on the CMA exam, think about the composition of debt and equity that produces “usable” assets, i.e liquid ones that either are cash or can generate cash quickly.
Expanding the Investment Base
You might have head finance professionals refer to “expanding the investment base.” More often than not, this refers to the use of debt as a larger portion of funding of useful assets.
The reason investors want to “expand the base” is to generate more absolute profit in the company per 1 dollar initial investment. For example, imagine you invest $10,000 in a watch company. With those $10,000, the company is able to generate $4000 per year in business.
However, if the company takes on another $10,000 in debt, it can generate $8000 per year. And if it takes on another $10,000, it generates $12,000 per year. Since debt payments are spread over long periods, the payout in dividends on your initial $10,000 will be around $10,000 per year. In two years, you double your investment.
This principle is called leverage. By expanding the investment base, investors leverage the use of debt to increase their own return on investment.
