Key Terms: What Is ‘Capital Employed’?
The term ‘Capital Employed’ is one that comes up commonly in property investment. It is, however, used in several contexts, making it somewhat difficult to pin down a specific definition.
Essentially, ‘Capital Employed’ can be defined as the total amount of capital utilised for the acquisition of profits. It can also refer to the total value of all fixed and working capital assets employed in a business. Fundamentally, all definitions of ‘Capital Employed’ tend to refer to the investment and functioning of a business.
Capital Employed is a figure used by analysts in order to determine the subsequent Return on Capital Employed (ROCE). It is a form of probability ratio, which compares net operating profit to the Capital Employed sum, informing investors as to how much each £ of earnings is generated with each £ of Capital Employed.
Many analysts consider ROCE to be a better indication of performance or profitability over a long-term period than alternative figures of return on equity or return on assets. This is because it is believed that ROCE takes long term financing into consideration in a way that the alternatives.
How To Calculate Capital Employed
In simple terms, Capital Employed is a measure of the value of a business’s total assets minus its current liabilities. Rather than total liabilities, which may come to significantly more, a current liability refers only to the portion of debts that are required to be repaid within one year.
In order to calculate the sum of Capital Employed, you’ll first need to calculate both your total assets and current liabilities.
In order to calculate Capital Employed from assets, add together the following:
- The current market value of the assets
- Investments into the business
- All current assets (stock, bills receivable, cash in hand etc)
From the liabilities side of a balance sheet, add together:
- Share capital, including issued share capital (Equity + Preference)
- Reserves and surplus sums. Include in this:
- Profit and Loss account
- General Reserve
- Capital Reserve
- Any other long term loans
Once you have calculated the sum of the current liabilities, deduct this from the total value of assets to determine your Capital Employed sum.
Similarly to the calculation of return on assets, investors use the sum of return on Capital Employed to give them an approximate figure for what their return is likely to be in the future.
What About Return on Capital Employed (ROCE)?
Return on Capital Employed is the logical next step calculation after you have worked out Capital Employed. It is calculated by dividing net operating profit (or earnings before interest and taxes) by employed capital.
Alternatively, you could divide the sum of earnings before interest and taxes by the difference between total assets and current liabilities.
There is also a separate financial ratio that you can calculate: the return on average capital employed, or ROACE.
ROACE: Return on Average Capital Employed
ROACE shows the value of profitability against the investments that a company has made in itself. It’s important to note that this is a different calculation to ROCE, and has a very different meaning, so be sure to understand the difference when making your calculations.
The Return on Average Capital Employed calculation takes the average of the opening and closing capital of a period of time, rather than just the capital figure generated at the end of that period.
The calculation of Return on Average Capital Employed looks like this:
ROACE = Earnings before interest and taxes (EBIT) / (Average Total Assets – Average Current Liabilities)
ROACE is a useful calculation to make when you are analysing a business within an industry that relies heavily upon capital, such as property investment can do. If a business is able to generate higher profits from smaller capital assets, they will show a higher ROACE, and thus more efficiency in their capacity to convert capital to profit.
So What Does A Good Return on Capital Employed Look Like?
As with ROACE, an indication of an efficient company is one that demonstrates a high value of Return on Capital Employment, in terms of, at least in part, its Capital Employment. A high value may also indicate a company that has a lot of cash to hand (because cash is included within the total assets figure).
We hope that this explanation of how to calculate these valuable metrics has been useful to you. Of course, if you have any further queries regarding this, or any other term you’ve come across, please do get in touch. We are dedicated to making sure you get the most out of your investment portfolio, so we’re happy to help you every step of the way.
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