Table of Contents
- What Is Capital Employed?
- Key Takeaways
- Understanding Capital Employed
- Formula and Calculation of Capital Employed
- Return on Capital Employed (ROCE)
- Capital Employed vs. Equity
- Capital Employed in Small vs. Large Businesses
- Limitations of Capital Employed Metrics
- Example of How to Use Capital Employed
- What Is Capital Employed, and Why Is It Important in Finance?
- What Is a Good Return on Capital Employed?
- What Is Return on Average Capital Employed?
- How Do You Calculate Capital Employed From a Company’s Balance Sheet?
- How Can Businesses Optimize Their Capital Employed?
- The Bottom Line
What Is Capital Employed?
Let me explain capital employed to you directly—it's also known as funds employed, and it measures the total amount of money a company has spent to generate profits. You use this figure alongside other financial metrics to evaluate the company's return on assets, showing how effective management is at deploying its capital. Companies also rely on it to assess expenditures on specific projects.
Key Takeaways
You can calculate capital employed by subtracting current liabilities from total assets, or by adding noncurrent liabilities to owners’ equity. This metric reveals how much capital is actively used to make an investment profitable. Return on capital employed, or ROCE, is a standard way to gauge the return on that investment.
Understanding Capital Employed
Capital employed gives you a clear snapshot of how a company invests its money, though it's a term that's often used but hard to pin down precisely because it fits so many contexts. Generally, it refers to the capital investment needed for a business to operate. This includes stocks and long-term liabilities, as well as the value of assets in use. Put simply, it's the value of assets minus current liabilities, both of which you find on the balance sheet. Current liabilities are debts due within a year, so capital employed offers a more accurate view of total assets. I recommend combining it with other data, like return on capital employed (ROCE), for better interpretation.
Formula and Calculation of Capital Employed
The formula for capital employed is straightforward: it's total assets minus current liabilities, or equivalently, equity plus noncurrent liabilities. You pull total assets from the balance sheet and subtract current liabilities, which are short-term obligations. Another approach is adding fixed assets to working capital, or combining equity from the shareholders’ equity section with noncurrent liabilities, meaning long-term debts.
Return on Capital Employed (ROCE)
Analysts mainly use capital employed to calculate return on capital employed, or ROCE, which gives an idea of potential future returns, similar to return on assets (ROA). ROCE is a profitability ratio that compares net operating profit to capital employed, showing how much earnings each dollar of capital generates. Some prefer ROCE over return on equity or ROA because it factors in long-term financing, providing a better measure of performance over time. A higher ROCE points to a more efficient company in terms of capital use, though high cash levels can sometimes inflate it. To check if a company's ROCE is good, compare it to peers in the same industry—the highest indicates the best profitability. You calculate ROCE by dividing EBIT by capital employed, or by dividing EBIT by total assets minus current liabilities. Comparing a company’s ROCE over years shows if profitability is rising or falling.
Capital Employed vs. Equity
Capital employed and equity serve different roles in a company’s structure. Equity is the shareholders' investments plus retained earnings. The key difference is that capital employed includes both equity and long-term debt, giving a broader view of performance. Equity focuses on ownership and shareholder returns, while capital employed reveals the overall financial structure. In analysis, capital employed appears in ratios like ROCE, and equity in ROE, together offering a full picture of efficiency and value.
Capital Employed in Small vs. Large Businesses
Capital employed matters more when comparing small and large businesses. For small ones, it often consists mostly of owner’s equity and limited debt, with a focus on liquidity and working capital to handle daily operations. They rely on personal investments, small loans, or reinvested profits, emphasizing tight control over inventory and payables due to scarcer resources. Large businesses have complex structures with significant equity and debt, investing in fixed assets like property and equipment. They secure cheaper financing and operate on a grander scale, allowing heavy investments in technology and infrastructure.
Limitations of Capital Employed Metrics
Calculating capital employed involves accounting estimates that can vary, like using historical cost versus fair value, leading to different results across companies. It often misses complexities like lease liabilities or off-balance-sheet items, which affect true financial health. External factors such as interest rates or market conditions can influence asset and liability values, making records fluctuate. Also, it typically ignores intangible assets like patents or brands, potentially understating a company’s value.
Alternatives to Capital Employed
- Return on assets (ROA) measures profit generation from all assets, including intangibles, by dividing net income by total assets.
- Return on equity (ROE) evaluates profit from shareholders’ equity, calculated as net income divided by equity.
- Economic value added (EVA) assesses profit after deducting capital costs, considering both equity and debt.
- Cash flow metrics like free cash flow (FCF) focus on operational cash after expenditures for liquidity insights.
- Industry-specific metrics, such as sales per square foot in retail, may better evaluate efficiency in certain sectors.
Example of How to Use Capital Employed
Consider the 2023 fiscal year for tech giants Alphabet, Apple, and Microsoft. Alphabet had EBIT of $86,144 million, total assets of $402,392 million, current liabilities of $119,013 million, so capital employed was $283,379 million and ROCE 0.3039. Apple: EBIT $114,301 million, assets $352,583 million, liabilities $290,437 million, capital employed $62,146 million, ROCE 1.8392. Microsoft: EBIT $88,523 million, assets $411,976 million, liabilities $205,753 million, capital employed $206,223 million, ROCE 0.4292. Apple’s 183.9% ROCE means it generated nearly $2 in profits per dollar of capital, highlighting efficiency and financing strategies.
What Is Capital Employed, and Why Is It Important in Finance?
Capital employed is the total funds in a company’s operations, including equity and debt. It’s vital in finance to show resource use for profits and assess health.
What Is a Good Return on Capital Employed?
A higher ROCE is better, as it shows more profit per dollar of capital employed.
What Is Return on Average Capital Employed?
ROACE measures profitability against average investments, dividing EBIT by average assets minus average liabilities, differing from ROCE by using averages.
How Do You Calculate Capital Employed From a Company’s Balance Sheet?
Start with net fixed assets (PP&E), add capital investments and current assets, then subtract current liabilities like accounts payable or short-term debt.
How Can Businesses Optimize Their Capital Employed?
Optimize by improving asset efficiency, managing working capital, refinancing debt cheaply, and choosing high-return projects.
The Bottom Line
Capital employed is the total capital used for profits, including stocks, long-term liabilities, and operational assets, providing insight into money usage. Calculate it by subtracting current liabilities from total assets or adding noncurrent liabilities to equity. Use it for ROCE to measure investment returns—a higher value means better efficiency.
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