How to Calculate Capital Employed

Capital employed is a term frequently used in business and finance to assess the total value of resources invested in a company. While the precise definition may vary slightly depending on the context or accounting framework, in general, it represents the amount of money or financial resources that a business has deployed in its operations to generate profit. Understanding capital employed is crucial for evaluating a company’s financial health, operational efficiency, and profitability.

Significance of Capital Employed in Business

1. Financial Health and Efficiency: Capital employed is a key indicator of a company’s financial health. It reflects how much money has been invested in the business to sustain its operations. Companies that employ large amounts of capital are often seen as more stable, as they are better equipped to handle economic fluctuations or to invest in growth opportunities. However, it’s important to note that having too much capital employed without corresponding profitability can indicate inefficiency.

2. Operational Efficiency: By assessing how well a company uses its capital to generate profits, analysts can gain insights into its operational efficiency. Capital employed is used in ratios such as ROCE, which helps investors determine how effectively the company is generating profit from its capital. A high return on capital employed indicates that the company is using its capital efficiently, while a low ROCE may suggest that capital is being underutilized or that the business is struggling with profitability.

3. Investment and Financing Decisions: Investors, lenders, and financial analysts use capital employed to assess the financial viability of a company. For investors, the ability to generate significant returns on capital is a key determinant of whether to invest in the company. Lenders, on the other hand, may use capital employed to evaluate the risk of lending to the company, as a higher capital employed ratio can indicate that the company has a substantial base of assets and financing to repay its debts.

4. Growth Potential: The amount of capital employed also speaks to a company’s growth potential. A company that has significant capital employed might be better positioned to expand its operations, invest in new technologies, or enter new markets. Conversely, if capital employed is low, it could indicate that the company lacks the resources to grow or is overly reliant on debt to finance operations.

5. Profitability Analysis: For profitability analysis, capital employed is important because it is directly linked to the return a company is generating. The ability to generate a higher return on capital employed (ROCE) relative to the cost of capital is often a sign of a well-managed business. Companies that can achieve high returns on the capital they employ are typically more attractive to investors, as this means they are generating more profits relative to the resources they have invested.

Formula:
Capital Employed = Total assets − Current liabilities
Or: = Total share capital + reserves + current liabilities + loan capital
Or: = Equity + non-current liabilities
Or: = Non-current assets + working capital
Or: = ordinary share capital + reserves

Example:
Company ABC has the following data:
Buildings $150,000
Furnitures $20,000
Stocks $32,000
Debtors $8,000
Cash $5,000
Creditors $55,000
Bank overdraft $45,000

Then,
Fixed assets = 150,000 + 20,000 = $170,000
Current assets = 32,000 + 8,000 + 5,000 = $45,000
Total assets = Fixed assets + Current assets = 170,000 + 45,000 = $215,000
Current liabilities = Creditors + Bank overdraft = 55,000 + 45,000 = $100,000
Capital Employed = Total assets − Current liabilities = 215,000 - 100,000 = $115,000