Capital is a broad term that confers value or benefits to its owners like equipment, machinery, or property. Generally, capital refers to the cash used for investment, often at the time of establishing a business. In this way, capital employed is the money or funds employed for acquiring profits and generating earnings. But, working out capital employed is not as simple as it seems, so before discussing how to work out capital employed, let’s understand what actually capital employed is?
Understanding Capital Employed
In simple words, capital employed is the money or net operational assets deployed by a business to generate profits. If you want to measure the profitability ratio or efficiency of the capital use, use the CE figure in Return on Capital Employed (ROCE) to get the profitability ratio. It is an effective metric to work out the return on investment (ROI) and to see how effective the management is at getting the maximum return (profit) from the capital used.
How to Work out Capital Employed?
Here is the simple formula to work out the capital employed:
Capital Employed = Total Assets – Current Liabilities
Here, the total assets refer to the total book value of all the assets, whereas the total current liabilities are the liabilities that are due within a year.
Suppose that the total assets of the company ABC are worth £50,0000 and its total current liabilities listed in the balance sheet are over £32,0000. Let’s calculate it:
CE= Total Assets (£50,0000) – Total Current Liabilities (£32,0000)= £18,0000
Another way to work out the capital employed is:
Capital Employed = Fixed Assets + Working Capital (Current Assets– Current Liabilities)
In this formula, fixed assets refer to the capital assets that are used for the long-term by the company and play an important role in the company’s operations. These include plant, property, machinery, etc.
In the second example let’s suppose the fixed assets of a company ABC are worth £50 million. Its current liabilities cost £20 million and its current assets are £25 million. By subtracting current liabilities from the current assets, you get the working capital of £5 million.
Let’s put these values into the formula:
CE= Fixed Assets + Working Capital (Current Assets- Current Liabilities)
CE= £50 million + ( £25 – £20 million)
CE= £55 million
Working capital is the capital that we used to meet the daily business operations and is calculated as current assets minus current liabilities.
Bear in mind that you shouldn’t switch the formula to conduct trend analysis or peer comparisons as the calculation differs as per the use of the formula. Mostly, the first formula is frequently used to work out the capital employed.
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What Capital Employed Shows?
Capital employed can provide an overview of how a company makes investments. It can be used in different contexts. However, all the definitions refer to the investment required to run a business. Stocks and long term liabilities are the common types of capital investments.
It also indicates the value of the assets used to run a business. You can work it out by subtracting current liabilities from the value of assets. You can find both of these measures on the balance sheet. Current liabilities must be paid within the timeframe of a year. Hence, capital employed provides a precise estimate of the total assets.
What is Return on Capital Employed (ROCE)?
Capital employed is essentially used for working out the return on capital employed (ROCE). Investors use ROCE metric to get an estimated value of what their return might be in the coming times. ROCE is considered a profitability ratio. It compares net operating profit to capital employed. And let investors know how much return is earned with the money invested.
ROCE helps you to gauge the profitability or effectiveness of the company for a longer period. A higher return on capital employed indicates that a company is working efficiently, in terms of capital employed. In addition, it may also indicate that a business has a lot of cash in hand. Hence, more cash can sometimes imbalance this metric.
To calculate ROCE, you need to use this formula:
Quick Sum Up
So, after giving this post a read, you have now learned how to work out capital employed, what does capital employed indicates and what is a return on capital employed (ROCE). In a nutshell, capital employed is the money invested to generate profit. It tells whether or not a business is efficiently investing to make income. Moreover, capital employed is used to work out the return on capital investment. ROCE is the profitability ratio.
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Disclaimer: This blog is intended for general information on the above topic.