Overview
Capital Employed refers to the total value of the capital that a company uses to generate profits. It can be measured in two primary ways:
- Shareholders’ Equity and Long-Term Debt: Capital Employed is computed by summing the shareholders’ equity with the company’s long-term debt.
- Fixed Assets and Net Current Assets: Alternatively, it is calculated by summing the fixed assets of the company along with the net current assets.
Even though it is not legally defined or required to be disclosed in the company’s balance sheet, understanding Capital Employed is crucial for performing various financial analyses, particularly in determining the Return on Capital Employed (ROCE), which measures the efficiency and profitability of a company’s capital investments.
Examples
-
Example 1: Using Shareholders’ Equity and Long-Term Debt
- Shareholders’ Equity: $4 million
- Long-Term Debt: $2 million
- Capital Employed = Shareholders’ Equity + Long-Term Debt = $4 million + $2 million = $6 million
-
Example 2: Using Fixed Assets and Net Current Assets
- Fixed Assets: $3 million
- Current Assets: $2.5 million
- Current Liabilities: $1 million
- Net Current Assets = Current Assets - Current Liabilities = $2.5 million - $1 million = $1.5 million
- Capital Employed = Fixed Assets + Net Current Assets = $3 million + $1.5 million = $4.5 million
Frequently Asked Questions
What is Capital Employed used for?
Capital Employed is primarily used to assess how effectively a company is using its capital to generate profits. It is a key metric in ratio analysis, particularly in calculating the Return on Capital Employed (ROCE).
How is Return on Capital Employed (ROCE) calculated?
Return on Capital Employed (ROCE) is calculated by dividing the company’s operating profit by the capital employed. The formula is: \[ \text{ROCE} = \frac{\text{Operating Profit}}{\text{Capital Employed}} \times 100 \]
What is the difference between Capital Employed and Capital Invested?
Capital Employed includes the total amount of capital that a company uses in its operations, while Capital Invested refers specifically to the funds invested in the company by equity shareholders and debt holders.
Is Capital Employed the same as Total Assets?
No, Capital Employed is not the same as Total Assets. Capital Employed can be calculated by subtracting current liabilities from total assets or by adding shareholders’ equity and long-term debt.
Why is Capital Employed important for investors?
Capital Employed is an important metric for investors because it provides insight into how efficiently a company is using its capital to generate profits. High ROCE values suggest effective use of capital, whereas low ROCE values may indicate inefficiencies.
Does Capital Employed include short-term liabilities?
No, short-term liabilities are not included directly in the calculation of Capital Employed. When using the fixed assets and net current assets method, current liabilities are deducted from current assets to calculate net current assets.
How can a company improve its Capital Employed?
A company can improve its Capital Employed by increasing its earnings, reducing inefficiencies, better managing its assets, and optimizing its debt levels.
What is the relationship between Capital Employed and Working Capital?
Working Capital is the difference between current assets and current liabilities. It is a component of Capital Employed when using the fixed assets and net current assets approach.
Can Capital Employed be negative?
In practice, Capital Employed is usually positive, as it represents the capital used for generating profits. Negative Capital Employed would indicate the company’s liabilities exceed its assets, which is usually not sustainable.
Where can I find Capital Employed in financial statements?
Capital Employed is not explicitly outlined in financial statements but can be inferred using the balance sheet by computing shareholders’ equity plus long-term debt or fixed assets plus net current assets.
Related Terms
Shareholders’ Equity
The amount of equity capital in a company owned by shareholders, it represents the net value of a company’s assets minus its liabilities.
Long-Term Debt
A company’s financial obligations that are due beyond one year, often involving loans or bonds.
Fixed Assets
Long-term tangible assets that a company uses in its operations to generate income over time, such as buildings, machinery, and equipment.
Net Current Assets
The difference between a company’s current assets and current liabilities, indicating the liquidity available to meet short-term obligations.
Balance Sheet
A financial statement that provides a snapshot of a company’s financial condition by listing assets, liabilities, and shareholders’ equity at a specific point in time.
Ratio Analysis
A quantitative method of gaining insight into a company’s liquidity, operational efficiency, and profitability by comparing various financial metrics obtained from financial statements.
Return on Capital Employed (ROCE)
A financial ratio that measures the efficiency and profitability of a company’s capital investments by dividing operating profit by capital employed.
Online References
- Investopedia: Capital Employed
- Investopedia: Return on Capital Employed (ROCE)
- Corporate Finance Institute: Capital Employed
- Accounting Tools: Capital Employed
Suggested Books for Further Studies
- “Financial Accounting” by Walter T. Harrison Jr.
- “Principles of Managerial Finance” by Lawrence J. Gitman and Chad J. Zutter
- “Financial Statement Analysis and Security Valuation” by Stephen H. Penman
- “Fundamentals of Financial Management” by Eugene F. Brigham and Joel F. Houston
Accounting Basics: “Capital Employed” Fundamentals Quiz
Thank you for exploring the concept of Capital Employed and testing your knowledge with our focused quiz. Continue advancing your understanding of financial metrics to enhance your analytical skills in accounting and finance!
