Any business worthwhile must deploy (or invest) capital to build a long-term existence.
And as a forward-thinking small business owner, you need to know certain financial metrics: Capital Employed (CE) is one of them.
In this guide, we’ll explain everything you need to know about CE — from its definition and calculation to its limitations.
What does Capital Employed mean?
CE, also known as funds employed, refers to the total capital your business invests to generate profits.
When you calculate CE, you find out how efficiently your company invests this capital.
They also measure the value of your company’s assets based on its current liabilities, which are debts that must be repaid within 12 months.
Essentially, your CE calculation indicates whether your company has the assets necessary to cover its debts, which may come due within a year.
If your calculation shows that your company does not have the necessary assets to meet its liabilities, it means that your company is not investing its capital efficiently.
What is the formula for calculating the capital employed?
The easiest way to calculate CE is to look at your balance sheet.
You can solve it in two ways. The most common formula is as follows:
CE = Total Assets (total book value of assets) – Current Liabilities (debts due within one year)
First, determine the net value of your fixed assets.
These can be found in the non-current assets section of your balance sheet.
Second, add your capital investments, including any financing or investments from individuals, venture capitalists, or financial institutions.
Third, add up your current assets. These are assets that can be liquidated (converted into cash) in 12 months or less, such as: B. Cash on hand, cash in business bank accounts, stocks and bills receivable. To determine the value of your assets, you can use the purchase price or alternatively the acquisition cost after depreciation, which will give you a more accurate value.
Finally, subtract your current liabilities, which are short-term financial obligations that are due within 12 months. These include accounts payable, current debt, dividends payable and accrued costs.
Let’s assume the following financial information applies to your company:
Current assets: £150,000
Long-term assets: £350,000
Current liabilities: £60,000
Long-term liabilities: £150,000
CE = Current assets: £150,000 + Non-current assets: £350,000 – Current liabilities: £60,000 = £440,000
A second way to calculate CE is to use this formula:
CE = fixed assets (e.g. property, plant and equipment) + working capital (current assets less current liabilities)
First, determine the net value of your fixed assets. This will be listed as property, plant and equipment on your balance sheet.
Second, you increase working capital by subtracting your current liabilities from current assets.
Each formula can lead to a different result. Therefore, to analyze trends or compare CE with your industry peers, it is important to be consistent in your choice of calculation and avoid switching between formulas.
What is the return on capital employed?
CE is often combined with Return On CE (ROCE), a profitability measure used by investors and stakeholders to get an idea of what their future returns might be.
It compares net operating profit to CE and gives a percentage indication of how much profit is generated from each pound of CE.
Here is the formula to calculate ROCE:
Earnings before interest and taxes (EBIT) / CE x 100
Imagine your company has the following financial information:
Total assets: £200,000
Current liabilities: £50,000
EBIT: £30,000.
CE = Total Assets: £200,000 – Current Liabilities: £50,000 = £150,000
ROCE = £30,000 / £150,000 x 100 = 20%
This means that your company generates an ROCE of 20%.
What is a good return on capital employed?
In general, the higher the ROCE, the more efficient your company is in terms of the profit it makes per pound of CE.
However, it can also mean that your company has a large cash balance because cash is included in the balance sheet totals, which can skew the calculation.
A ROCE of at least 15% to 20% is a good goal for your company.
However, this is not a hard and fast rule as ROCE depends on the industry in which your company operates. For example, it is not uncommon for it to be more than 25% in manufacturing and only 5 to 15% in retail.
Percentages aside, your company should plan to generate ROCE that is consistently above its weighted average cost of capital.
In other words, your company should generate a higher return on the funds provided to it than the average cost of financing, which includes debt and equity.
If you want to assess whether your company has a good ROCE, you can also compare your company’s ROCE with previous years, with the ROCE of other companies in the same industry, or with both.
Limitations on capital employed
For all its advantages, CE also has its limitations.
First, CE creates a snapshot – rather than a comprehensive picture – of your company’s financial obligations.
For example, hidden obligations such as lease liabilities, contingent liabilities, and other assets and liabilities that do not appear on your balance sheet can have a significant impact on your company’s financial position — even if they are not part of your CE calculation.
Second, CE can be affected by external factors such as interest rate or inflation fluctuations or market conditions, which affect the value of your assets and liabilities in your CE calculation.
Third, CE captures your physical assets such as property and equipment, but does not capture intangible assets such as patents. This can cause you to unintentionally undervalue your business.
To get a more holistic view of your company’s financial performance, you can use some complementary metrics.
Return on equity (ROE) examines how efficiently your company generates profits from its equity.
The formula is:
Annual surplus/equity
And return on assets (ROA) takes into account how efficiently your company uses its assets to generate profits. The advantage of ROA is that it takes into account physical and non-physical assets such as intellectual property.
The formula is:
Net Income / Total Assets
Final thoughts
If you want to set solid goals for your company, CE is a good place to start.
Keep track of the amount of capital deployed in your business to get a clear overview of its profitability and efficiency.
As a standalone financial metric, CE provides a helpful overview of your company’s financial health.
However, when combined with ROE and ROA, it provides a more comprehensive statement about your company — particularly how well it uses not only capital, but also equity and assets to generate profits.
