Capital Employed

What is Capital Employed?

Capital employed (CE) is the total capital a firm uses in a specific period in the form of investments, acquisitions, and other profit-generating activities. 

It also imparts information about how a business is investing its money. In other words, we can also say that it depicts the value of assets used by the business to generate earnings.

• It tells you how much of the investment has been used to expand a business
• It is used to compute the Return on Capital Employed (ROCE). ROCE is a standard metric used to determine the return on investment
• ROCE also tells you about the profitability of a business and how efficiently the capital is being used

Equity and capital employed are not the same. Equity capital is money a business has raised through common stock, preferred stock, initial public offering (IPO), and retained earnings. 

The distinction is that the firm can utilize this capital to construct fixed assets or capital employed. Only capital used for current assets and capital fixed assets is considered capital employed.

Formula and Calculation of Capital Employed

We can calculate the amount of capital that is being employed by two methods, which are the following.

Method 1

The formula is:

Capital employed = Total assets - Current liabilities

Here,

1. Total assets

It is the entire value of the asset column of the balance sheet. Assets possess economic worth that an owner uses over time to reap benefits. 

Cash, marketable securities, inventory, accounts receivable, prepaid costs, fixed assets, intangible assets, etc., are only a few categories in which assets can be categorized.

2. Current liabilities

It is a corporate obligation that must be paid within a year or an operational cycle. Additionally, current debts are settled with either a new current liability or a current asset like cash. 

Short-term debt, accrued obligations, accounts payable, and other similar items are current liabilities seen on a company's balance sheet.

In simple words, the amount of capital used for generating profits can be calculated by subtracting current liabilities from the book value of all assets.

The total value of all assets includes

• Fixed assets at their net worth. 
• Cash on hand, cash at the bank, bill receivables, and other current assets.
• All capital investments are made into the business.

Sample Calculation

The business's balance sheet is all the values required for computing the amount of CE. 

Here, 

• Total assets = Current assets + Non-current assets      
• Total assets = $4,000,000 + $7,000,000 = $11,000,000
• Current liabilities = $1,000,000

We know, 

CE = Total assets - Current liabilities

Therefore,

CE = $11,000,000 - $1,000,000 = $10,000,000

Method 2

CE = Non-current Assets + Working Capital

Here,

1. Non-current assets: The sum of the company's long-term investments is not recognized throughout an accounting year. Plant and equipment, real estate, patents, interests in other businesses, and other items are non-current assets. The balance sheet of the corporation includes non-current assets.
2. Working capital: It is the difference between current assets and current liabilities. It is utilized in the company's daily operations and transactions.

Sample Calculation

Let's check the table below:

The business's balance sheet is all the values required for computing the CE. 

Here,

• Working capital = Current assets - Current liabilities
• Working Capital = $4,000,000- $1,000,000 = $3,000,000
• Non-current assets = $7,000,000

We know,

CE = Non-current assets + working capital

Therefore,

CE = $7,000,000 + $3,000,000 = $10,000,000

• Calculating CE from Balance Sheet: First, determine the net worth of all fixed assets on the company's balance sheet. This amount will be shown in the "property, plant, and equipment" section (PP&E). This sum should be increased by the total value of all capital and current asset investments.

From this amount, deduct all current liabilities. These include any obligations with a one-year or shorter due date. Current obligations are accounts payable, short-term loans, and dividends payable on a company's balance sheet.

Uses of Capital Employed

To determine how capital used impacts a company's overall performance, an analysis may be done using the amount of capital employed. It may also assess how a company's capital employed is changing. 

Comparing capital utilized over time can be used to achieve this. This demonstrates how successful a company's capital spending strategy is.

It also depicts how well a company uses its resources to generate profits, determined using a metric called Return on Capital Employed (ROCE). 

Return on Capital Employed (ROCE)

It is a profitability ratio used to measure the profitability of the business and the efficiency with which the business is using its capital. 

It shows how much operating income is generated per dollar of investment. It is expressed as a percentage.

ROCE = Earnings before interest and tax (EBIT) / CE

A higher ROCE depicts that the capital is being used efficiently. The ROCE should be compared either empirically or with the industry or peer group. 

However, the disadvantage of ROCE is that it compares the return to the book value of the company's assets.

• Even though the cash flow has not changed, the ROCE will rise as they are depreciated.
• Older companies with depreciated assets would, therefore, often have greater ROCE than more recent, possibly superior companies.
• Inflation also has an impact on cash flow but not on asset book value. As a result, revenues generally rise in line with inflation while capital utilized typically does not, as inflation does not affect the book value of assets.

Example of ROCE

ROCE is particularly helpful for assessing the performance of businesses in capital-intensive industries like utilities and telecommunications. 

This is so because ROCE takes debt and equity into account, in contrast to other fundamentals like return on equity (ROE), which solely assesses profitability connected to a company's shareholders' equity. For businesses with high debt, this can help neutralize financial performance analyses.

From the above, we have the amount of CE as $10,000,000.

Let us assume that the business's EBIT, also known as the operating profit, is $1,500,000. 
EBIT is calculated by subtracting expenses except for taxes and interest from revenue. 

We know,

ROCE = Earnings before interest and tax (EBIT) / CE

Therefore,

ROCE = $1,500,000 / $10,000,000 = 0.15 = 15%

It depicts that for every dollar of capital employed, the business is earning 15 cents on it. Investors are curious about a company's long-term financing plans and its ratio to determine how well it spends its CE.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Analysis of Financial Statements
• Liability
• Liquidity
• Equity
• Capital