1. What is Capital Employed?
In accounting and finance, capital employed refers to the amount of capital investment a business has used to run its operations. It is a measure of all the resources a company has at its disposal to generate profits. Typically, it includes net assets, long-term liabilities, and equity. It’s essentially the total resources a company has financed, either through debt or equity.
2. Importance of Capital Employed
Capital employed is a crucial measure as it helps in assessing the efficiency and productivity of a company. It’s used in several key financial ratios, such as Return on Capital Employed (ROCE), which measures a company’s profitability in relation to the capital used. A high ROCE indicates efficient use of capital.
Capital employed also gives investors an idea of how a company is utilizing its resources. If a company’s capital employed is increasing over time, it might mean that the company is investing more in its business, which could potentially lead to higher returns in the future.
3. Types of Capital Employed
Broadly, capital employed can be categorized into two types:
- Debt Capital: This includes loans and other forms of debt that the company has to pay back. It’s a liability for the company.
- Equity Capital: This includes share capital and retained earnings. It represents the ownership interest in the company.
4. Formula on Capital Employed
There are multiple ways to calculate capital employed, depending on the information available and the context. Here are a few common methods:
- Total Assets minus Current Liabilities: This is probably the most common way to calculate capital employed. It basically includes all the resources a company has, excluding short-term debts.
- Shareholders’ Equity plus Long-Term Liabilities: This calculation method focuses on how the company’s resources have been financed.
- Fixed Assets plus Working Capital: This method focuses on the company’s operational investment.
5. Examples of Capital Employed
Let’s consider a simple example to illustrate the concept:
If a company has total assets worth $500,000 and current liabilities of $200,000, the capital employed would be $500,000 – $200,000 = $300,000 using the first formula.
If the same company has shareholders’ equity of $150,000 and long-term liabilities of $150,000, then the capital employed would be $150,000 + $150,000 = $300,000 using the second formula.
6. Issues and Limitations of Capital Employed
While capital employed is a useful measure, it has several limitations:
- It can be calculated in different ways, which can lead to inconsistencies when comparing different companies.
- It does not take into account the quality of the assets. For example, obsolete machinery may still be included in the total assets.
- It does not consider the future earning potential of the assets. For instance, a company may have high capital employed due to heavy investment in research and development, but the returns from such investments may not be realized immediately.
- It is a static measure and does not provide insights into the dynamics of a business. For example, it won’t tell you if the company is increasing its capital efficiency over time.
- It doesn’t account for the risk associated with the business. Two companies may have the same capital employed, but one may be operating in a much riskier industry.