Adjusted average capital employed

What Is Adjusted Average Capital Employed?

Adjusted average capital employed represents a refined financial metric within Corporate Valuation that quantifies the total capital utilized by a business to generate its profits, after accounting for specific adjustments and typically averaged over a period. Unlike raw Capital Employed, which is often a static figure derived directly from the Balance Sheet, adjusted average capital employed seeks to provide a more accurate and economically relevant measure of the long-term investment base in a company. This metric is crucial for analysts and investors aiming to assess a company's operational efficiency and return generation capacity over time, offering a clearer picture than a single point-in-time calculation.

History and Origin

The concept of capital employed itself has been a cornerstone of financial analysis for decades, serving as a fundamental measure of the resources a business deploys. However, standard accounting practices, while adhering to principles set by bodies like the Financial Accounting Standards Board (FASB) in its Accounting Standards Codification⁵, sometimes present a view that may not fully reflect the economic reality of a company's invested capital. For instance, differing approaches to valuing Assets, such as historical cost versus Fair Value accounting, or the treatment of certain Liabilities like operating leases, can obscure the true capital base.

The evolution toward "adjusted" and "average" forms of capital employed arose from practitioners' and academics' efforts to overcome these limitations and provide a more robust basis for performance evaluation and Valuation models. The need for such adjustments is highlighted by discussions around the impact of accounting estimates and judgments on capital employed metrics. Academic research, such as studies on "adjusted net assets methodology," specifically addresses the importance of adjusting balance sheet items to reflect market prices or fair values for a more accurate valuation.⁴ Similarly, regulatory bodies like the Securities and Exchange Commission (SEC) have emphasized the importance of proper valuation, particularly for assets where market quotations are not readily available, as seen in their Rule 2a-5 under the Investment Company Act of 1940.³ This ongoing refinement in financial reporting and analysis underscores the continuous drive to present a more economically sound measure of a company's capital.

Key Takeaways

• Refined Metric: Adjusted average capital employed offers a more economically accurate view of a company's invested capital by making specific adjustments to standard balance sheet figures.
• Performance Assessment: It is primarily used to evaluate how efficiently a company is utilizing its long-term capital to generate profits over a period, rather than at a single point in time.
• Valuation Basis: This metric serves as a foundational component in various Economic Profit and value-based management frameworks.
• Time-Weighted: The "average" component typically involves averaging the capital employed over multiple periods (e.g., beginning and ending balances), smoothing out fluctuations.

Formula and Calculation

The calculation of adjusted average capital employed begins with the standard definition of capital employed, which can be expressed as total Assets minus current liabilities, or as Shareholder Equity plus non-current liabilities. From this base, specific adjustments are made to reflect the economic reality of the capital utilized. The "average" aspect typically involves taking the average of the adjusted capital employed at the beginning and end of a period (e.g., year, quarter).

A common base for capital employed is:
$\text{Capital Employed} = \text{Total Assets} - \text{Current Liabilities}$
or
$\text{Capital Employed} = \text{Shareholder Equity} + \text{Non-current Liabilities}$

Adjustments might include:

• Adding back accumulated Depreciation and Amortization to reflect the gross investment in productive assets.
• Capitalizing operating leases (treating them as finance leases, thereby adding the leased assets to assets and lease liabilities to debt).
• Adjusting for surplus cash (subtracting cash beyond operating needs).
• Including off-balance sheet financing.
• Adjusting for revaluations of assets to their Fair Value where appropriate for a more current economic measure.

The adjusted average capital employed formula could conceptually look like this, where adjustments are added to or subtracted from the traditional capital employed, and then averaged:

$\text{Adjusted Average Capital Employed} = \frac{(\text{Adjusted Capital Employed}_{\text{Beginning}} + \text{Adjusted Capital Employed}_{\text{End}})}{2}$

Where:

• (\text{Adjusted Capital Employed}) is the total capital used by the business after applying specific economic or analytical adjustments.
• (\text{Beginning}) refers to the start of the period (e.g., fiscal year).
• (\text{End}) refers to the end of the period.

The exact nature of adjustments can vary significantly based on the purpose of the analysis and the industry.

Interpreting the Adjusted Average Capital Employed

Interpreting adjusted average capital employed involves assessing how effectively a company is deploying its resources to generate operating profits. A consistently high and increasing return relative to adjusted average capital employed, often calculated as Return on Capital Employed (ROCE), signals efficient capital allocation and strong management performance. This metric provides a more stable and representative picture of the capital base by smoothing out period-end distortions and incorporating economic adjustments.

When analyzing the figure, it is important to consider industry benchmarks. Capital-intensive industries, for instance, naturally require higher capital employed than service-oriented businesses. The trend of adjusted average capital employed over several periods can also reveal whether a company's growth is being supported by proportional or disproportionate increases in capital, which in turn impacts its long-term profitability and value creation.

Hypothetical Example

Consider "Alpha Manufacturing Inc." which reports the following financial data:

Year 1 End:

• Total Assets: $1,200,000
• Current Liabilities: $250,000
• Accumulated Depreciation (Book Value): $300,000 (assumed for adjustment)
• Operating Lease Obligation (Off-balance sheet, for adjustment): $100,000

Year 2 End:

• Total Assets: $1,400,000
• Current Liabilities: $300,000
• Accumulated Depreciation (Book Value): $350,000
• Operating Lease Obligation (Off-balance sheet, for adjustment): $120,000

Let's calculate the adjusted capital employed for each year and then the adjusted average capital employed for Year 2 (using Year 1 end as beginning of Year 2, and Year 2 end).

Adjustments Policy: For this example, we will adjust by adding back accumulated depreciation and capitalizing operating lease obligations.

Year 1 Adjusted Capital Employed:

1. Base Capital Employed = Total Assets - Current Liabilities = $1,200,000 - $250,000 = $950,000
2. Add back Accumulated Depreciation: $950,000 + $300,000 = $1,250,000
3. Add Capitalized Operating Lease: $1,250,000 + $100,000 = $1,350,000
   Adjusted Capital Employed (Year 1 End) = $1,350,000

Year 2 Adjusted Capital Employed:

1. Base Capital Employed = Total Assets - Current Liabilities = $1,400,000 - $300,000 = $1,100,000
2. Add back Accumulated Depreciation: $1,100,000 + $350,000 = $1,450,000
3. Add Capitalized Operating Lease: $1,450,000 + $120,000 = $1,570,000
   Adjusted Capital Employed (Year 2 End) = $1,570,000

Adjusted Average Capital Employed for Year 2:
$\text{Adjusted Average Capital Employed} = \frac{(\text{Adjusted Capital Employed}_{\text{Year 1 End}} + \text{Adjusted Capital Employed}_{\text{Year 2 End}})}{2}$
$\text{Adjusted Average Capital Employed} = \frac{(\$1,350,000 + \$1,570,000)}{2} = \frac{\$2,920,000}{2} = \$1,460,000$

This $1,460,000 represents the average capital base, adjusted for these specific items, that Alpha Manufacturing Inc. utilized during Year 2 to generate its operating profits. This figure would then be used in ratios like ROCE to assess the company's efficiency over that period.

Practical Applications

Adjusted average capital employed finds extensive use in various financial analyses, particularly in areas requiring a deep dive into a company's operational efficiency and intrinsic value.

One primary application is in calculating value-based metrics such as Economic Value Added (EVA) or Cash Value Added (CVA), which often require a more economically sound measure of the capital base. These metrics are central to Performance Measurement and incentive compensation schemes in many corporations.

Furthermore, adjusted average capital employed is vital in Mergers and Acquisitions (M&A) and capital budgeting decisions. During due diligence, potential acquirers may adjust a target company's reported capital employed to understand the true economic capital generating its earnings, which then informs the offer price. For internal capital allocation, it helps management evaluate the returns from new Capital Expenditures against a clearer, more comparable capital base.

In regulatory contexts, while regulators typically prescribe specific accounting standards, the underlying principles of fair value and proper asset valuation, as articulated by the SEC, are crucial for accurate financial reporting, which indirectly supports the rationale for such analytical adjustments.² The transparency and accuracy of Financial Statements are paramount for investor protection and market integrity.

Limitations and Criticisms

While adjusted average capital employed provides a more robust analytical tool, it is not without limitations. A significant challenge lies in the subjectivity of the adjustments themselves. There is no universally agreed-upon set of adjustments, and the choice of which items to adjust, and how, can vary based on the analyst's discretion and the specific industry. This can lead to inconsistencies when comparing companies if different adjustment methodologies are applied.

Another criticism relates to the complexity involved. Performing comprehensive adjustments requires a deep understanding of accounting nuances and access to detailed financial information, which may not always be publicly available. Over-reliance on adjusted metrics without understanding the underlying assumptions can lead to misinterpretations.

Furthermore, similar to other capital-based ratios, adjusted average capital employed can still be influenced by factors beyond operational efficiency, such as significant one-off asset revaluations or changes in accounting policies. The Bankrate article on Return on Capital Employed (ROCE) notes that metrics based on capital employed can be susceptible to manipulation through financial engineering or accounting techniques, and may not fully account for external factors like inflation.¹ While "adjusted" aims to mitigate this, some inherent vulnerabilities remain. The use of historical costs for many Assets on financial statements, even with adjustments, may not fully capture the current market value or replacement cost of the capital employed.

Adjusted Average Capital Employed vs. Capital Employed

The key distinction between adjusted average capital employed and raw Capital Employed lies in their underlying philosophy and application.

While capital employed provides a simple measure of a company's invested capital, adjusted average capital employed seeks to refine this figure by incorporating a more comprehensive view of the company's true long-term resource deployment, often bridging the gap between accounting figures and economic realities for improved analysis.

FAQs

What is the primary purpose of adjusting capital employed?

The primary purpose of adjusting capital employed is to derive a more accurate and economically meaningful measure of the capital base that a company is truly utilizing to generate its profits. This refined figure helps in better assessing operational efficiency, Profitability, and overall value creation, especially when conducting in-depth financial analysis or Valuation.

Why is it "average" instead of just a point-in-time figure?

Averaging the adjusted capital employed (typically over the beginning and end of a period) helps to smooth out short-term fluctuations that might occur due to seasonal factors, specific transactions, or accounting cut-offs. Using an average provides a more representative measure of the capital base that was utilized throughout the entire period, making ratios like Return on Capital Employed more reliable for trend analysis and comparisons.

What kind of adjustments are typically made?

Common adjustments to capital employed include adding back accumulated depreciation (to reflect gross investment in Property, Plant, and Equipment), capitalizing operating leases (to treat them as owned assets financed by debt), and adjusting for non-operating assets or surplus cash. The goal of these adjustments is to include all capital that contributes to generating operating profits and exclude any that do not.

Is adjusted average capital employed used by all companies?

Adjusted average capital employed is not a standard accounting metric reported by companies in their Financial Statements. Instead, it is an analytical tool primarily used by financial analysts, investors, and internal management for more nuanced performance evaluation, strategic planning, and Net Present Value calculations in valuation models. Its use varies depending on the depth of analysis required.