What is capital employed and how is it calculated?

Any business worth its salt must use (or invest) capital in order to build longevity.

And as a future-focused small business owner, there are certain financial metrics you need to know: 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 is the meaning of capital employed?

CE, also known as funds employed, refers to the total capital your business invests in order to generate profit.

When you calculate CE, you find out how efficiently your business invests that capital.

You also gauge the value of your business assets against its current liabilities, which is debt that must be repaid within 12 months.

Essentially, your CE calculation indicates whether your business has the assets required to cover its debts that may fall due within a year.

If your calculation shows that your business doesn’t have the necessary assets to meet its liabilities, this means your business isn’t investing its capital efficiently.

What is the formula to calculate capital employed?

The simplest way to calculate CE is by looking at your balance sheet.

You can work it out in 2 ways. The most common formula is as follows:

CE = Total assets (total book value of assets) – Current liabilities (debts that fall due within a year)

Firstly, find the net value of your fixed assets.

You can find this listed in the non-current (long-term) asset section of your balance sheet.

Secondly, add your capital investments, which includes any funding or investments from an individual, venture capital, or financial institution.

Thirdly, add your current assets. These are assets that can be liquidated (converted in cash) in 12 months or less, such as cash in hand, cash in business bank accounts, stocks, and bills receivable. To get the value of your assets, you can use the purchase price or, alternatively, the cost after depreciation, which will give you a more accurate figure.

Lastly, subtract your current liabilities, which are short-term financial obligations that fall due within 12 months. These include accounts payable, short-term debt, dividends payable, and accrued expenses.

Let’s assume the following financial information applies to your company:

Current assets: £150,000

Non-current assets: £350,000

Current liabilities: £60,000

Non-current 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 by using this formula:

CE = Fixed assets (such as property, plant and equipment) + Working capital (current assets minus current liabilities)

Firstly, find the net value of your fixed assets. This is listed as property, plant, and equipment on your balance sheet.

Secondly, add working capital, by subtracting your current liabilities from current assets.

Each formula may produce a different result so, for the purposes of analysing trends or comparing CE with your industry peers, it’s important to be consistent with your choice of calculation and avoid switching between formulas.

What is return on capital employed?

CE is often combined with Return On CE (ROCE), a profitability ratio used by investors and stakeholders to get an idea of what their future return may look like.

It compares net operating profit with CE and provides an indication of how much profit is generated by each pound of CE, in percentage terms.

Here’s 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 your company generates a 20% ROCE.

What is a good return on capital employed?

In general, the higher the ROCE, the more efficient your business is in terms of the profit it’s generating per pound of CE.

But it can equally mean that your business has a lot of cash on hand because total assets includes cash, which can skew the calculation.

A ROCE of at least 15% to 20% is a good target for your business to aim for.

This isn’t a hard-and-fast rule though because ROCE depends on the industry your business operates in. For instance, it’s not uncommon for it to be higher than 25% in manufacturing and as low as 5% to 15% in the retail sector.

Percentages aside, your business should plan to generate ROCE that is consistently more than its weighted average cost of capital.

In other words, your business should generate a larger return on the funds injected into the business than the average cost of funding, which includes debt and equity.

If you want to gauge whether your company has a good ROCE, you can also compare your company’s ROCE to previous years, to other companies’ ROCE in the same industry or both.

Limitations of capital employed

For all its benefits, CE also has its limitations.

Firstly, CE creates a snapshot—rather than a comprehensive picture—of your company’s financial commitments.

For instance, hidden obligations, such as lease liabilities, contingent liabilities, and other assets and liabilities that don’t appear on your balance sheet can have a sizeable impact on the financial condition of your business—even though they don’t form part of your CE calculation.

Secondly, CE can be affected by external considerations, such as interest or inflation fluctuations or market conditions that affect the value of your assets and liabilities in your CE calculation.

Thirdly, CE accounts for your physical assets, such as property and equipment, but it doesn’t capture intangible assets, like patents. This can result in you inadvertently undervaluing your business.

To get a more holistic view of your company’s financial performance, there are a couple of complementary metrics you can use.

Return on equity (ROE) looks at how efficiently your company generates profit from shareholders’ equity.

The formula is:

Net income / Shareholders’ equity

And return on assets (ROA) considers how efficiently your business uses its assets to generate profit. The advantage ROA has is that it accounts for physical and non-physical assets, such as intellectual property.

The formula is:

Net income / Total assets

Final thoughts

If you’re looking to set solid targets for your business, CE is a good place to start.

Keep tabs on the amount of capital deployed in your business to give you a clear indication of its profitability and efficiency.

As a standalone financial metric, CE provides a helpful snapshot of your company’s financial health.

But when combined with ROE and ROA, it tells a more complete story about your business—specifically, how well it’s employing not only capital to generate profit, but also equity and assets.