A company's balance sheet offers a snapshot of how a company utilizes its capital resources at a given point in time. To perform a capital-employed analysis, focus on funds being used during the operating cycle and from where those funds come. The most important items to identify are fixed assets, inventories, trade receivables, and payables.
Capital-employed provides a snapshot of how a company invests its money. However, it can be problematic to define capital-employed because there are so many contexts in which it can exist. However, most definitions generally refer to the capital investment necessary for a business to function.
Capital investments include stocks and long-term liabilities, but it can also refer to the value of assets used in the operation of a business. Put simply, 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). Like return on assets (ROA), investors use ROCE to get an approximate estimate of what their return might be in the future. Return on capital employed (ROCE) is thought of as a profitability ratio. It compares net operating profit to capital employed and informs investors how much each dollar of earnings is generated with each dollar of capital employed.
Capital employed is financed by capital invested. Pay attention to shareholders' equity, net debt and other long-term assets and liabilities. This provides a sense of future capital flexibility.
Capital Employed Analysis
Capital employed is a catch-all phrase. No fixed or universal definitions explain what capital employed means—or, rather, different definitions are based on different contexts.
The simplest presentation of capital employed is total assets minus current liabilities. Sometimes, it is equal to all current equity plus interest-generating loans (non-current liabilities).
Fundamental investors most frequently refer to capital employed as part of the return on capital employed (ROCE) or return on average capital employed (ROACE) metrics. ROCE and ROACE compare the company's profitability to the total investments made in new capital.
Some consider capital employed as long-term liabilities plus share capital plus profit and loss reserves. In this circumstance, net assets employed is always equal to capital employed.
Return On Capital Employed - ROCE
The simple method of determining capital employed by looking at a balance sheet involves four steps:
• Locate the net value of all fixed assets. It's easiest to use original cost, but some prefer to use replacement cost after depreciation.
• Add all capital investments into the business.
• Add cash in hand, cash at bank, bills receivable, stock and other current assets.
• Subtract current liabilities.
Check out the answer to our FAQ - What does a high capital employed imply about risk?