Meaning and definition of Capital Employed
Generally, capital employed is presented as deducting the current liabilities from the total assets. It can be defined as equity plus loans which are subject to interest. To define it properly, capital employed can be expressed as the total amount of capital that has been utilized for acquisition of profits. It also refers to the value of all assets (fixed as well as working capital) employed in a business.
As explained by Investopedia, capital employed is a term that s used commonly, but is a little difficult to be defined for it is used in different contexts. However, all the definitions usually refer to the investment required for the functioning of a business. “Employing capital” indicates making an investment in the business.
Capital Employed Formula
The general formula used for computing capital employed is:
or Capital Employed = Total Assets – Current Liabilities
It is important to note that short-term debt, such as accounts payable and taxes payable, are not included in the calculation of capital employed, as they are considered to be a normal part of a company's operating cycle and are not used to finance long-term investments.
Once capital employed has been calculated, it can be used to evaluate a company's financial performance and efficiency in generating returns from its capital investment. For example, the ROCE ratio compares the company's earnings before interest and taxes (EBIT) to its capital employed, providing a measure of the company's ability to generate returns from the capital invested in the business.
Calculating Capital Employed
Generally, the capital employed can be calculated through two methods as mentioned below:
The first method involves calculating capital employed from the assets side and is worked out by adding up the following:
I. The fixed assets are included in their net values, be it original cost or the replacement cost after depreciation. In times of inflation, it is advisable to count fixed assets at the replacement cost which is actually the current market value of the assets.
II. Investments into the business.
III. All current assets like cash in hand, sundry debtors, cash at bank, bills receivable, stock, and similar more.
IV. To determine the capital employed, current liabilities are subtracted from the total of fixed assets, investments, and current assets.
As an alternative to the first method, capital employed can also be calculated from the liabilities side of a balance sheet. While calculating from the liabilities side, the following items will be included:
I. Share capital which includes issued share capital (Equity + Preference).
II. Reserves and Surplus that includes General reserve, Capital reserve, Profit & Loss account, and other long-term liabilities (excluding interest-bearing debt).
III. Interest-bearing debt which includes all long-term debt that the company has issued, including bonds, loans, and other borrowings.
IV. To evaluate the capital employed, the sum of share capital, reserves and surplus, and interest-bearing debt is deducted from the total assets’ worth, less current liabilities.
In both methods, the resulting capital employed figure represents the total amount of funds that a company has invested in its operations, including both equity and debt financing. This figure is used in financial analysis to evaluate a company's financial performance and efficiency in generating returns from its capital investment.
Negative Capital Employed
While it is technically possible for capital employed to be negative, it is not a desirable or common situation. In general, capital employed represents the total amount of funds that a company has invested in its operations, including both equity and debt financing. A negative capital employed figure would imply that a company has more current liabilities than the total of its fixed assets, investments, and current assets. This would indicate that the company is not generating enough revenue to cover its operating expenses and may be relying on borrowing to continue operating.
Negative capital employed can occur in some industries, particularly in asset-light businesses where the company doesn't require significant investments in fixed assets, such as consulting or software companies. However, in most cases, negative capital employed is a warning sign of financial distress and may indicate that a company is in danger of defaulting on its obligations or may be at risk of bankruptcy. It is important for investors and analysts to carefully evaluate the reasons for negative capital employed and to assess the financial health and prospects of the company before making any investment decisions.