What is Capital Employed?

What is Capital Employed?

Capital employed is the total amount of equity invested in a business. The amount of capital employed can be derived in several ways, some of which yield differing results. The alternative formulations of capital employed are noted below. Whichever method is used should be employed consistently. By doing so, one can plot the level of capital employed on a trend line.

The amount of capital employed can be compared to net sales to arrive at a ratio of capital employed to sales. The result can then be compared to the same ratio for competitors, to determine which businesses are doing the best job of efficiently using their capital to generate sales.

Formula of Capital Employed

This metric can be calculated in two ways:

Capital Employed = Total Assets – Current Liabilities

Where:

  • Total Assets are the total book value of all assets.
  • Current Liabilities are liabilities due within a year.

or,

Capital Employed = Fixed Assets + Working Capital

Where:

  • Fixed Assets, also known as capital assets, are assets that are purchased for long-term use and are vital to the operations of the company. Examples are property, plant, and equipment (PP&E).
  • Working Capital is the capital available for daily operations and is calculated as current assets minus current liabilities.
  • Note: The formula chosen should be consistently applied (do not switch between formulas when conducting trend analysis or peer comparisons) as the calculation differs depending on which formula is used. Generally, total assets minus current liabilities is the most commonly used formula.

What Capital Employed Can Tell You

Capital employed can give a snapshot of how a company is investing its money. However, it is a frequently used term that is at the same time very difficult to define because there are so many contexts in which it can be used. All definitions generally refer to the capital investment necessary for a business to function.

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Capital investments include stocks and long-term liabilities. It also refers to the value of assets used in the operation of a business. In other words, it is a measure of the value of assets minus current liabilities. Both of these measures can be found on the balance sheet. A current liability is the portion of debt that must be paid back within one year. In this way, capital employed is a more accurate estimate of total assets.

Capital employed is better interpreted by combining it with other information to form an analysis metric such as return on capital employed (ROCE).

What is Return on Capital Employed?

Return on capital employed (ROCE) is a financial ratio. It refers to how much a company’s capital employed has grown. It is the capital employed multiplied by the percentage of capital employed. The return on capital figure can be used to determine what percentage of successful growth was had during that time period. This ratio gives the business an idea of the return on each dollar of capital employed.

Here is a practical example. On the balance sheet, if we assume our capital employed grew from $50,000 to $70,000, we can assume that the return on capital employed is 40%. This means during X time frame, our capital employed grew by 40%.

Return on Capital Employed

(Capital Employed – Beginning Capital Employed) x 100 / (Beginning Capital Employed + Ending Capital Employed)

The value of knowing capital employed

By calculating the capital employed within a business it is possible to create a snapshot of the efficiency with which that business is investing its money. These capital investments could include stocks and long-term liabilities, although the capital employed calculation also produces a simple measure of the value of assets held by the business against the current liabilities that need to be paid back within a year.

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In other words, a capital employed calculation will make it plain whether a business has the assets needed to cover all its debts that might fall due within a relatively short period of time. If this is not the case then the capital employed calculation has revealed that the business has not been investing its capital in a particularly effective manner.  

What Is a Good Return on Capital Employed?

In general, the higher the return on capital employed (ROCE), the better it is for a company. The ROCE calculation shows how much profit a company generates for each dollar of capital employed. The higher the number (which is expressed as a percentage), the more profit the company is generating.

One way to determine if a company has a good return on capital employed is to compare the company’s ROCE to that of other companies in the same sector or industry. The highest ROCE indicates the company with the best profitability among those being compared.

Another way to determine if a company has a good ROCE is to compare it to the returns from previous years. If the ratios are trending down over a span of several years, it means the company’s profitability levels are declining. Conversely, if ROCE is increasing, this means the company’s profitability is increasing as well.