Capital employed in simple words refers to that capital which is used by the company for the running of the business so as to earn profit on the invested capital, here capital implies both owner’s capital as well as long term borrowings. In order to have a good grasp about this term, one should look at some of the frequently asked questions on capital employed –
Capital Employed FAQS
Formula for Capital Employed
There are two formulas for calculation of capital employed while one formula is Capital Employed = Total Assets – Current Liabilities where total assets represent all the assets whether its current assets or fixed assets and current liabilities include items like sundry creditors, bills payable, outstanding expense and all the debt which are repayable within a year. In the second formula, one has to deduct working capital from non-current assets, here non-current assets imply all the assets except current assets while working capital is calculated as = Current assets – Current Liabilities.
How to Calculate Capital Employed from Balance Sheet
Capital employed can be calculated in two ways from the balance sheet one is from the asset side of the balance sheet and another way is to calculate it from the liability side of the balance sheet. If one is calculating it from asset side than one will have to add all the fixed assets, investments, intangible assets like goodwill, trademarks, patents and working capital which is calculated as current assets less current liabilities. If one is calculating it from the liability side than one will have to add equity share capital, preference share capital, debentures, long term loans, and all reserves in order to arrive at the figure of capital employed.
What is Return on Capital Employed
Return on capital employed is a measure of profitability which measures how the company is using the capital to generate profits. It is calculated as EBIT divided by capital employed where EBIT is calculated by subtracting the cost of goods sold and operating expenses from the sales done by the company whereas calculation of capital employed is already explained above. Higher the ratio better it is as it implies that the company is using the capital efficiently in generating profits.
What is the difference between Capital Employed and Equity
Equity represents the funds which are invested by the owners of the company but as far as capital employed is concerned it represents not only the funds invested by the owners of the company but also the long term liabilities incurred by the company and that is the reason why capital employed will always be higher than equity due to presence of long term liabilities in its computation.
What is Average Capital Employed
Average capital employed as the name suggests is the average of opening capital employed and closing capital employed which is arrived at by dividing the sum of opening and closing capital employed by 2. The calculation of capital employed will remain the same as explained above the only thing extra is the calculation of both opening as well as closing capital employed.
What is Return on Average Capital Employed
Return on average capital employed is another measure of profitability like return on capital employed the only difference between the two is that in this case, one takes an average of opening and closing capital for a given period of time to arrive at the ratio the rest of the things remains same. In this case also higher the ratio better it is as far company and investors are concerned.
Difference between Capital Employed and Net Worth
Net worth is different from capital employed in the sense that while net worth is simply the total of equity share capital, preference share capital, reserves and surplus while capital employed is net worth plus all the long term liabilities and hence in simple words, net worth is simply the value of owners holding in the company while capital employed is total of owners funds as well as outsiders funds.
Use of Capital Employed
Capital employed is used by the analysts in the calculation of return on capital employed so as to determine how well the company is using capital for generating the profits and is an indicator of the efficiency in case of high ratio or inefficiency in case of low ratio of the company as well as top management of the company.
Is Cash included in Capital Employed
The answer to this question is yes because cash in hand and cash at the bank are nothing but part of current assets and as explained above while calculating capital employed all assets whether its fixed assets or current assets are included in the calculation.
ROE VS ROCE
ROE is the acronym for return on equity and it only shows the return which the company is generating for its equity shareholders as it is calculated as net profit divided by shareholders equity while ROCE is the acronym for return on capital employed and it shows the return which the company is generating for its equity shareholders as well as long term creditors who have given debt to the company and it is calculated as EBIT divided by capital employed. Hence if you are an investor and invested into the equity of the company than ROE is a better measure to look for however if you want to analyze the company’s profitability as a whole than ROCE is a better measure.