Capital-employed analysis is a method of evaluating how a company uses its capital resources to generate profits. It involves calculating the amount of capital employed, which is the value of assets minus current liabilities, and comparing it with the earnings before interest and tax (EBIT) to measure the return on capital employed (ROCE). ROCE is a profitability ratio that shows how much operating income is generated per dollar of invested capital.
To perform a capital-employed analysis, you need to follow these steps:
- Obtain the balance sheet of the company and identify the total assets, current liabilities, fixed assets, working capital, and EBIT.
- Choose one of the two formulas to calculate capital employed:
- Capital Employed = Total Assets – Current Liabilities
- Capital Employed = Fixed Assets + Working Capital
- Use the same formula consistently and compare it with the EBIT to calculate ROCE:
- ROCE = EBIT / Capital Employed
- Interpret the ROCE ratio and compare it with the industry average or the company’s historical performance to assess the profitability and efficiency of capital use.
To illustrate this process, let’s use a hypothetical scenario with some real numbers. Suppose you want to analyze the capital-employed performance of XYZ Company, which has the following balance sheet data for the year 2023 (in thousands of dollars):
| Balance Sheet Items | Amount |
|---|---|
| Total Assets | 500 |
| Current Liabilities | 100 |
| Fixed Assets | 300 |
| Working Capital | 200 |
| EBIT | 50 |
Using the first formula, we can calculate the capital employed as follows:
Capital Employed = Total Assets – Current Liabilities Capital Employed = 500 – 100 Capital Employed = 400
Using the second formula, we can calculate the capital employed as follows:
Capital Employed = Fixed Assets + Working Capital Capital Employed = 300 + 200 Capital Employed = 500
As you can see, the two formulas give different results, so you need to choose one and stick to it. For simplicity, let’s use the first formula, which is more commonly used. Then, we can calculate the ROCE as follows:
ROCE = EBIT / Capital Employed ROCE = 50 / 400 ROCE = 0.125 or 12.5%
This means that for every dollar of capital employed, XYZ Company generates 12.5 cents of operating income. To evaluate this ratio, we need to compare it with the industry average or the company’s historical performance. For example, if the industry average ROCE is 15%, then XYZ Company is underperforming its peers. If the company’s ROCE in the previous year was 10%, then XYZ Company is improving its profitability and efficiency of capital use.
One alternative approach to capital-employed analysis is to use invested capital instead of capital employed. Invested capital is the sum of equity and debt, which represents the total amount of funds invested in the company by shareholders and creditors. The formula for invested capital is:
Invested Capital = Equity + Debt
Using this formula, we can calculate the invested capital of XYZ Company as follows (assuming that the company has 200 of equity and 200 of debt):
Invested Capital = Equity + Debt Invested Capital = 200 + 200 Invested Capital = 400
Then, we can calculate the return on invested capital (ROIC) as follows:
ROIC = EBIT / Invested Capital ROIC = 50 / 400 ROIC = 0.125 or 12.5%
As you can see, the ROIC is the same as the ROCE in this case, because the capital employed and the invested capital are equal. However, this may not be true for other companies that have different capital structures. The advantage of using ROIC is that it reflects the cost of capital and the leverage effect of debt. The disadvantage is that it may not capture the value of assets used in the operation of the business.
