What is capital employed (plain language)
– Capital employed estimates the funds a business has put to work in its operations. In practice it represents the value of assets used to run the business after subtracting short‑term obligations that must be paid within a year.
– Why it matters: combined with operating profit, capital employed helps measure how efficiently management turns invested capital into operating earnings.
Core definitions
– Total assets: everything the company owns that has value on the balance sheet (cash, inventory, property, receivables, etc.).
– Current liabilities: obligations due within 12 months (short‑term debt, accounts payable, accrued expenses).
– Noncurrent (long‑term) liabilities: obligations due after 12 months (long‑term debt, bonds, long‑term leases).
– Equity: owners’ claim — share capital plus retained earnings.
– Capital employed (CE): the operating capital base used to generate profits. Common algebraic forms:
– CE = Total assets − Current liabilities
– CE = Equity + Noncurrent (long‑term) liabilities
How to calculate capital employed — step‑by‑step checklist
1. Obtain the company balance sheet (statement of financial position) for the period you want to analyze.
2. Read or total the “Total assets” line.
3. Identify “Current liabilities” (total short‑term obligations) and subtract them from total assets:
– Capital employed = Total assets − Current liabilities
4. Alternatively, add equity and noncurrent liabilities:
– Capital employed = Equity + Noncurrent liabilities
5. If you want an average for a period, compute opening CE and closing CE and take the arithmetic mean:
– Average CE = (CE at beginning of period + CE at end of period) / 2
Return on Capital Employed (ROCE)
– Purpose: ROCE expresses operating profitability relative to capital employed. It helps compare companies with different capital structures or assess returns over time.
– Standard formula:
– ROCE = EBIT / Capital employed
– where EBIT = Earnings Before Interest and Taxes (net operating profit)
– Return on Average Capital Employed (to smooth timing effects):
– ROACE = EBIT / Average capital employed
Interpreting ROCE
– Higher ROCE generally indicates more efficient use of capital.
– Compare ROCE to:
– peers in the same industry (capital intensity varies by sector),
– the company’s historical ROCE trend,
– the company’s cost of capital (e.g., weighted average cost of capital or WACC): ROCE above WACC suggests value creation.
– Watch for distortions: unusually high cash balances, one‑off gains in EBIT, or differing accounting practices.
Worked numeric example
– Given on a company’s balance sheet:
– Total assets = $1,200,000
– Current liabilities = $300,000
– Equity = $600,000
– Noncurrent liabilities = $300,000
– EBIT (most recent year) = $180,000
– Compute capital employed:
– CE = Total assets − Current liabilities = $1,200,000 − $300,000 = $900,000
– (Check: Equity + Noncurrent liabilities = $600,000 + $300,000 = $900,000)
– Compute ROCE:
– ROCE = EBIT / CE = $180,000 / $900,000 = 0.20 → 20%
– If opening CE was $800,000 and closing CE $900,000:
– Average CE = ($800,000 + $900,000) / 2 = $850,000
– ROACE = $180,000 / $850,000 ≈ 21.2%
Common uses
– Compare operating efficiency among firms in the same sector.
– Track a company’s trend in using capital over multiple years.
– Evaluate whether new investments are likely to earn returns above existing projects or the company’s cost of capital.
Limitations and cautions
– Accounting variability: differences in depreciation policy, inventory method, lease accounting, and recognition of
and recognition of intangible items (for example, treatment of internally generated research and development). These accounting choices change both the numerator (profit measures) and denominator (capital base), so ROCE or ROACE comparisons can be misleading unless you know how each company measures and presents its figures.
Other important limitations and cautions
– Off-balance-sheet items: Operating leases used to be off-balance-sheet and may still be inconsistently reported across jurisdictions or periods. Under modern standards (IFRS 16 / ASC 842) many leases now appear on the balance sheet, but transitional and disclosure differences persist.
– Non-operating assets and liabilities: Large holdings of excess cash, short-term marketable securities, or minority investments inflate capital employed without supporting operating returns. Decide whether to exclude these when comparing operating performance.
– One-off and nonrecurring items: Exceptional gains or losses can distort EBIT (earnings before interest and taxes). Use adjusted operating profit (normalized EBIT) for clearer operational comparisons.
– Capital structure and tax effects: ROCE uses operating profit before interest, so it isolates operating efficiency from financing cost. It does not, however, reflect after-tax returns available to equity holders.
– Industry differences and capital intensity: Capital employed will naturally be larger for heavy industries (utilities, telecom, airlines) relative to software or services firms. Use sector peers or percentiles rather than absolute targets.
– Timing and averaging: Capital is a stock (balance-sheet) item while EBIT is a flow (income statement). Use average capital employed (opening + closing / 2) for a year to reduce timing mismatch—especially for rapidly growing or shrinking firms.
– Inflation and historical costs: Balance sheet items measured at historical cost understate replacement cost in inflationary periods, biasing the metric upward.
Practical checklist — how to compute and compare capital employed and ROCE
1. Choose a consistent definition of capital employed (CE). Common variants:
– CE1 = Equity + Noncurrent liabilities
– CE2 = Total assets − Current liabilities
– CE3 = Total assets − Current liabilities − Non-operating cash & marketable securities (if you want operating CE)
2. Extract numbers from the balance sheet:
– Equity: shareholders’ equity / total equity
– Noncurrent liabilities: sum long-term debt, capital leases, deferred tax liabilities, pension obligations, and other noncurrent borrowings. Use closing balances consistent with your CE formula.
– Total assets: the sum of current and noncurrent assets from the balance sheet.
– Current liabilities: trade payables, short-term debt, accrued expenses and other obligations due within one year.
– Non-operating cash & marketable securities: cash and short-term investments not needed for operations (management disclosures or segment info can help identify these).
– Minority interest / noncontrolling interest: include if you used total equity that includes it; match your CE definition to how equity is presented.
3. Choose and extract the operating-profit numerator:
– EBIT (earnings before interest and taxes) is the most common numerator for ROCE (return on capital employed). EBIT measures operating profit before financing and tax.
– If you prefer after-tax operating return, compute NOPAT (net operating profit after tax) = EBIT × (1 − tax rate). Use statutory or an effective tax rate appropriate for the company.
– Be consistent across comparables (don’t mix EBIT and NOPAT when benchmarking peers).
4. Average capital employed:
– Use an average to smooth timing effects: Average CE = (Opening CE + Closing CE) / 2.
– For seasonal or fast-changing businesses, consider a quarterly average (sum of quarterly CE / number of quarters).
– If balance-sheet reclassifications occur, restate opening numbers to match closing presentation.
5. Compute ROCE:
– ROCE (using EBIT) = EBIT / Average CE.
– If using NOPAT, call the metric ROIC (return on invested capital) = NOPAT / Average CE.
– Example: Opening CE = 500; Closing CE = 600 → Average CE = (500 + 600)/2 = 550. If EBIT = 110, then ROCE = 110 / 550 = 0.20 = 20%.
6. Worked example with an operating-only CE:
– Data (end of year values): Total assets = 1,200; Current liabilities = 300; Non-operating cash & securities = 50.
– CE2 (assets − current liabilities) = 1,200 − 300 = 900.
– CE3 (operating CE) = 900 − 50 = 850.
– If Opening CE3 = 760, Average CE3 = (760 + 850)/2 = 805.
– EBIT (year) = 160. ROCE = 160 / 805 = 19.9%.
7. Practical checklist before comparing companies:
– Confirm which CE variant you’re using (CE1, CE2, CE3). Use the same across peers.
– Verify you’re using operating profit consistently (EBIT vs NOPAT).
– Average the capital base for the same period as the profit figure (annual profit vs average capital over the year).
– Adjust for one-offs in EBIT (restructure costs, asset disposals) to see core operating return.
– Check leases, pensions, and off-balance-sheet items—accounting changes (e.g., IFRS 16) can materially increase CE.
– Watch intangible-heavy firms: acquired goodwill and capitalized R&D can inflate CE relative to replacement economics.
– Compare ROCE to the firm’s weighted average cost of capital (WACC) to assess economic value creation—only as a diagnostic, not investment advice.
8. Common adjustments and how to handle them:
– Leases: Under IFRS 16 and similar standards, lessee balance sheets now recognize right-of-use assets and lease liabilities. Use consistent accounting standards for peers or restate if possible.
– Capitalized R&D: For comparability, consider
– Capitalized R&D: For comparability, consider restating R&D as an expense (i.e., remove capitalized R&D from assets and treat the expense in the income statement) or, if you keep capitalized R&D on the balance sheet, add the capitalized amount into capital employed so both numerator and denominator reflect the same treatment. If you expense R&D, reverse the capitalized balance-sheet amount and deduct accumulated amortization from fixed assets; if you capitalize, add a notional amortization charge to EBIT to reflect economic wear‑and‑tear.
– Pensions: For defined-benefit pension plans, include the net pension deficit (or subtract a surplus) in capital employed when it represents a long‑term claim on resources. For material plans, examine the sensitivity of CE and ROCE to actuarial assumptions.
– Excess cash and marketable securities: Remove non-operating cash (excess cash beyond normal working-capital needs) and short-term investments from capital employed if you want an operating ROCE. Define “excess” by industry norms or a rule of thumb (e.g., cash > 10% of revenues).
– Deferred tax and one-off tax items: Treat deferred tax balances consistently across peers. If deferred tax arises from timing differences on revaluations or tax losses, decide whether to include it in CE or to adjust equity; document your choice.
– Minority interests / non-controlling interests: Include the portion of capital employed that relates to minority shareholders if you are using consolidated EBIT (which includes the income attributable to all shareholders). Match numerator and denominator ownership bases.
– Non-operating assets: Remove investment property, financial investments, and assets held for sale from CE if you want to isolate operating capital. Alternatively, report an “operating CE” and a total CE that includes investments.
– Foreign currency effects: When averaging capital employed over a period, convert balance-sheet items using consistent exchange-rate treatment (e.g., average FX rate for the period) to avoid artificial volatility.
9. Step-by-step calculation checklist (practical)
– Step 1 — Choose the ROCE formula you will use and be consistent:
– Common form: ROCE = EBIT / Average Capital Employed
– EBIT = earnings before interest and taxes (operating profit).
– Average Capital Employed = (Opening CE + Closing CE) / 2.
– Alternative after-tax form (for economic profit comparisons): ROCEaftertax = EBIT*(1 − tax rate) / Average Capital Employed.
– Step 2 — Define capital employed (pick one consistent definition):
– Definition A (balance-sheet approach): CE = Total Assets − Current Liabilities (exclude interest-bearing short-term debt if you want operating CE).
– Definition B (claims approach): CE = Equity + Non-current (long-term) Liabilities.
– Definition C (operating assets approach): CE = Fixed Assets + Net Working Capital (current operating assets − current operating liabilities).
– Step 3 — Adjust for accounting quirks and one-offs (see bullets above).
– Step 4 — Compute opening and closing CE with the same definitions and adjustments; use averages.
– Step 5 — Insert adjusted EBIT and average CE into the ROCE formula.
– Step 6 — Benchmark vs peers and vs WACC (weighted average cost of capital) only as a diagnostic.
10. Worked numeric example
Assumptions (all amounts in $m):
– Opening total assets = 1,150; Opening current liabilities = 220 → Opening CE (Definition A) = 930.
– Closing total assets = 1,250; Closing current liabilities = 250 → Closing CE = 1,000.
– Company reported EBIT = 120 for the year.
– One-off restructuring charge included in EBIT = 20 (non-recurring); adjusted EBIT = 120 + 20 = 140 if restructuring reduced EBIT, or 120 − 20 if restructuring increased — here we assume it reduced reported EBIT, so we add it back to show core operating profit = 140.
– The company holds $80m excess cash (non-operating); we decide to exclude it from CE.
Step calculations:
– Average CE before removing excess cash = (930 + 1,000) / 2 = 965.
– Adjust average CE to exclude excess cash: Adjusted CE = 965 − 80 = 885.
– ROCE (adjusted) = Adjusted EBIT / Adjusted CE = 140 / 885 ≈ 15.8%.
Interpretation: The adjusted ROCE isolates operating performance and capital usage. Document each adjustment and why you made it.
11. Benchmarks, sector norms, and time horizons
– Capital intensity varies by industry: utilities and telecoms usually have high CE and lower ROCE; software companies often have low CE and high ROCE.
– Use multi-year ROCE trends to see whether returns are stable, improving, or deteriorating.
– Compare companies within the same accounting regime and with similar business models.
12. Limitations and common pitfalls
– Cross-accounting inconsistency: Different firms or countries may capitalize leases, R&D, or restructure differently; this distorts comparisons unless you restate.
– One-period snapshot bias: Using only year-end CE can be misleading for seasonal businesses; use averages.
– Measurement error: Book values differ from replacement cost; CE is an accounting construct, not an economic measure of required capital.
– Over-adjusting: Excessive adjustments can introduce subjectivity. Keep a clear audit trail for each change and, where possible, show unadjusted and adjusted ROCE side-by-side.
Quick analyst checklist before reporting ROCE
– Did I define CE clearly and apply it consistently?
– Did I adjust EBIT for one-offs and non-recurring items?
– Did I remove non-operating assets (excess cash, investments
, assets held for sale)? – Did I use an average for CE (opening + closing)/2 for seasonality-sensitive firms? – Have I capitalized lease obligations and added back corresponding right-of-use assets where appropriate? – Did I account for pension deficits or surpluses and other post-employment liabilities consistently? – Have I excluded minority (noncontrolling) interests or treated them consistently with the capital base definition? – Did I adjust for large acquisitions/disposals during the period (restate prior-period CE or use a time-weighted average)? – Are currency translation effects clarified if reporting on a consolidated basis across currencies? – Is each adjustment documented with source line items and rationale so a reviewer can reproduce the numbers?
Worked numeric example (step-by-step)
Assumptions (numbers in millions)
– EBIT (operating profit before interest and tax): 120
– Total assets at start of year: 1,200
– Total assets at end of year: 1,260
– Current liabilities at start of year: 420
– Current liabilities at end of year: 450
– Excess cash (non-operating) at start: 40; at end: 50
Step 1 — Compute Capital Employed (CE) at each date
– CE_start = Total assets_start − Current liabilities_start − Excess cash_start
= 1,200 − 420 − 40 = 740
– CE_end = Total assets_end − Current liabilities_end − Excess cash_end
= 1,260 − 450 − 50 = 760
Step 2 — Use average CE for the period
– Average CE = (CE_start + CE_end) / 2 = (740 + 760) / 2 = 750
Step 3 — Calculate ROCE
– ROCE = EBIT / Average CE = 120 / 750 = 0.16 = 16.0%
Step 4 — Sensitivity check
– If you instead used year-end CE only, ROCE = 120 / 760 = 15.8% (small difference)
– If you omitted excess cash removal, Average CE = ((1,200−420)+(1,260−450))/2 = (780+810)/2=795 → ROCE = 120/795 = 15.1% (material difference)
Interpretation: A 16% ROCE means the company generated 16 cents of operating profit for each dollar of capital employed over the year. To assess value creation you must compare ROCE to the firm’s weighted average cost of capital (WACC): ROCE above WACC implies operating returns exceed the cost of capital (subject to accounting caveats).
Quick reporting checklist before publishing ROCE
– State explicit CE definition (formula and inclusions/exclusions).
– Show both unadjusted and adjusted CE/ROCE for transparency.
– Supply working lines (assets, liabilities, excess cash, leases, pensions).
– Use averages for seasonal firms or show intra-year weighting if available.
– Disclose accounting-standard differences (IFRS vs. US GAAP) that affect comparability.
– Note material one-offs and show ROCE with and without them.
Common pitfalls to flag for readers
– Comparing across firms without restatements for leases, pensions, or capitalized vs. expensed R&D leads to false conclusions.
– Using book values as proxies for economic replacement cost can misstate capital intensity.
– Over-adjusting transforms an objective ratio into a subjective estimate; preserve reproducibility.
Further reading and authoritative references
– IFRS Foundation — International Financial Reporting Standards: https://www.ifrs.org
– Financial Accounting Standards Board (FASB) — Accounting Standards: https://www.fasb.org
– U.S. Securities and Exchange Commission (SEC) — Financial Reporting Manual: https://www.sec.gov
– Investopedia — Capital Employed (overview article): https://www.investopedia.com/terms/c/capitalemployed.asp
– CFA Institute — Financial Statement Analysis (guidance on ratios): https://www.cfainstitute.org
Educational disclaimer
This explanation is educational and illustrative only. It is not individualized investment, tax, or accounting advice. Always verify figures in primary filings and consult a qualified advisor for decisions specific to your situation.