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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 the origin of those funds. The most important items to identify on a balance sheet when performing a capital-employed analysis are fixed assets, inventories, trade receivables, and payables.
Key Takeaways
- Investors and analysts will perform a capital-employed analysis because it highlights how a company is spending and investing its money.
- A company’s balance sheet provides the information necessary to calculate capital employed.
- Key metrics to review from a company’s balance sheet when performing a capital-employed analysis are inventories, fixed assets, receivables, and payables.
- A capital-employed analysis will generally take into consideration capital investments, such as the value of the assets required for the company to successfully operate.
- While there are various ways to measure capital employed, the simplest formula is to calculate total assets minus current liabilities.
Capital Investments
A capital-employed analysis provides useful information about how management invests a company’s 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 they can also refer to the value of assets used in the operation of a business. Put simply, capital employed is a measure of the value of assets minus current liabilities. Both of these measures can be found on a company’s balance sheet. A current liability is the portion of a company’s debt that must be paid back within one year. In this way, capital employed is a more accurate estimate of total assets.
Return on Capital Employed (ROCE)
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.
A company finances its capital employed through its capital investments. Pay attention to shareholders’ equity, net debt, and other long-term assets and liabilities when performing an analysis. These items provide a sense of future capital flexibility.
Capital Employed Analysis
As mentioned earlier, 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
Simple Method to Calculate Capital Employed
One of the simplest ways to determine capital employed is by reviewing a company’s balance sheet. This method involves four steps:
Locate the Net Value of All Fixed Assets
The non-current (or long-term) asset section of the balance sheet will include the company’s fixed assets. The section is referred to as property, plant, and equipment (PP&E). With the exception of land, fixed assets will be reported with their depreciated value.
Add Capital Investments
Add all capital investments that have come into the business. This can include any individual, financial institution, or venture capital funding or investments that have been made in the business.
Add Current Assets
In the assets section of the balance sheet, items are listed in order of their liquidity. Items that can be more easily converted to cash are at the top of the list. The list will be divided into current assets and non-current or long-term assets.
Current assets can be converted to cash in one year or less, while long-term assets take longer to convert. While it’s easiest to use the original cost, some companies prefer to use replacement cost after depreciation. Add to your calculation all current assets, including cash in hand, cash at banks, bills receivable, stock, and other current assets.
Subtract Current Liabilities
Current liabilities are a company’s short-term financial obligations, usually due within a year or less. You’ll find current liabilities reported on the company’s balance sheet. Examples include accounts payables, accrued expenses, short-term debt, and dividends payable.