How to Calculate Capital Employed
In the world of accounting and finance, understanding your company’s financial strength is crucial. One method to determine this is by calculating the ‘Capital Employed’. This blog post will break down what capital employed is, why it’s important and how you can calculate it for your business.
What is Capital Employed?
Capital employed, also known as funds employed, is a measure of the investment made in a business. It is essentially the total amount of capital used for the acquisition of profits. This metric is useful in comparing the total money invested versus the profits earned by a business. It can also aid in determining the efficiency and profitability of a company.
Why is Capital Employed Important?
Knowing the amount of capital employed can provide valuable insights into a company’s financial health and operational efficiency. Here are some reasons why it’s important:
- Profitability Analysis: The relationship between capital employed and the profits generated can reveal the efficiency of a company in using its capital.
- Performance Evaluation: Comparing the capital employed between different periods can help evaluate the company’s growth and performance over time.
- Investment Decision: Investors often use this metric to assess whether a company is worth investing in.
How to Calculate Capital Employed?
The calculation of capital employed can be done in two ways:
- Subtracting current liabilities from total assets.
- Adding equity to long-term liabilities.
Let’s delve deeper into these methods:
Method 1: Total Assets minus Current Liabilities
This method is based on the theory that the capital employed in a business is equal to the total assets minus the current liabilities. Here’s the formula:
Capital Employed = Total Assets – Current Liabilities
Method 2: Equity plus Long-term Liabilities
This method is based on the understanding that the capital employed in a business is the total of shareholders’ equity and long-term liabilities. Here’s the formula:
Capital Employed = Equity + Long-term Liabilities
Understanding the Calculation
The total assets of a company include all current and non-current assets. Current assets are resources that are expected to be converted into cash within one year, such as cash, accounts receivable, and inventory. Non-current assets are resources that provide long-term financial benefit, such as property, plant, and machinery.
Current liabilities are obligations that are due within one year, such as accounts payable, short-term loans, and other debts. Long-term liabilities are obligations that are due over a longer period.
Equity represents the shareholders’ stake in the company, which includes share capital and retained earnings.
Links to HMRC
For more information about the accounting terms used in this blog post, visit the following HMRC link. This guide offers a comprehensive overview of running a limited company, including detailed information on financial responsibilities.
Conclusion
Calculating capital employed is an important aspect of understanding a company’s profitability and efficiency. It provides crucial insights into how well a company is using its capital to generate profits. By understanding how to calculate capital employed, you can make more informed decisions about your business’s financial management.
