Adjusted capital employed indicator

What Is an Adjusted Capital Employed Indicator?

An Adjusted Capital Employed Indicator refers to a refined version of the traditional capital employed metric, which has been modified to provide a more accurate and comprehensive view of the capital truly utilized by a company to generate its operating profit. In the realm of financial analysis, this adjustment aims to strip away distortions caused by standard accounting practices or specific financial structures, offering a clearer picture of a business's operational efficiency and underlying asset base. This indicator falls under the broader category of valuation and performance measurement within corporate finance.

Adjustments are typically made to account for items that may obscure the true operational capital, such as off-balance-sheet financing, non-operating assets, or certain accounting treatments. By making these adjustments, analysts can achieve a more "apples-to-apples" comparison between companies, especially those in different industries or with varying capital structures. The goal of an Adjusted Capital Employed Indicator is to present a figure that truly reflects the long-term funds tied up in a business's core operations.

History and Origin

The concept of "capital employed" as a measure of a company's invested base has existed for decades, often serving as the denominator in key financial ratios like Return on Capital Employed (ROCE). However, as financial reporting standards evolved and companies adopted increasingly complex financial arrangements, the need for adjustments became apparent. One significant development that highlighted the necessity for an Adjusted Capital Employed Indicator was the introduction of International Financial Reporting Standard (IFRS) 16, which governs lease accounting.

Effective January 1, 2019, IFRS 16 largely eliminated the distinction between operating and finance leases for lessees, requiring nearly all leases to be recognized on the balance sheet as a "right-of-use" asset and a corresponding lease liability. This change significantly increased reported assets and liabilities for companies heavily reliant on leasing, impacting metrics such as total assets and leverage ratios. This shift enhanced transparency but also altered traditional financial metrics, making direct comparisons challenging without corresponding adjustments to capital employed. Academically, research has explored the systematic impact of IFRS 16 on key financial ratios, further underscoring the importance of understanding and potentially adjusting financial statements for a more accurate view of capital utilization.

Key Takeaways

• An Adjusted Capital Employed Indicator refines the traditional capital employed metric for more accurate financial analysis.
• Adjustments remove distortions from standard accounting practices or specific financial structures.
• It provides a clearer view of the capital invested in a company's core operations.
• This indicator is crucial for "apples-to-apples" comparisons between different companies or across time.
• The implementation of IFRS 16 underscored the need for such adjustments due to its impact on asset and liability reporting.

Formula and Calculation

While there isn't one universal formula for an Adjusted Capital Employed Indicator, the core idea is to start with a standard definition of capital employed and then make specific modifications.

The most common starting point for capital employed is:

Alternatively, it can be calculated as:

For an Adjusted Capital Employed Indicator, common adjustments might include:

• Capitalization of Operating Leases: Under previous accounting standards (e.g., IAS 17), many operating leases were off-balance-sheet. Following International Financial Reporting Standards (IFRS) 16, most leases are now capitalized. If analyzing historical data prior to IFRS 16, or if comparing with entities using different accounting principles, analysts might "capitalize" operating lease commitments by estimating the present value of future lease payments and adding them to both assets and debt.
• Exclusion of Non-Operating Assets: Assets not essential to the core business operations (e.g., excess cash beyond operational needs, marketable securities held for investment rather than liquidity, discontinued operations assets) may be subtracted from total assets.
• Inclusion of Capitalized R&D or Marketing Costs: In some cases, particularly for industries where research and development or significant marketing expenses drive long-term value, analysts might capitalize these expenditures and add them to capital employed, reversing their expensing on the income statement. This aims to reflect the economic investment in intangible assets.
• Adjustments for Goodwill or Intangible Assets: Depending on the purpose, adjustments might be made to goodwill or other intangible assets to reflect their true economic value or to remove accounting-driven distortions.

The formula for an Adjusted Capital Employed Indicator would then look like:

Where "Adjustments" could represent the sum of the changes described above. The specific adjustments depend on the analyst's objective and the industry context.

Interpreting the Adjusted Capital Employed Indicator

Interpreting the Adjusted Capital Employed Indicator involves understanding what the refined figure reveals about a company's operational efficiency and capital structure. A company with a lower Adjusted Capital Employed Indicator relative to its revenue or profit might be considered more capital-efficient, meaning it generates more output with less invested capital. Conversely, a higher adjusted figure could indicate a more capital-intensive business or potential inefficiencies in asset utilization.

Analysts primarily use the Adjusted Capital Employed Indicator as the denominator in profitability ratios such as Return on Capital Employed (ROCE). By using an adjusted figure, the resulting ROCE provides a more accurate assessment of how effectively a company is generating profits from the capital directly employed in its core operations, free from accounting noise or specific financing structures. This allows for better comparisons, especially when evaluating companies with different leasing policies or levels of non-operating assets.

Furthermore, a trend analysis of the Adjusted Capital Employed Indicator can reveal shifts in a company's investment strategy or capital intensity over time. For example, a rising adjusted capital employed without a corresponding increase in revenue or profit could signal declining capital efficiency or significant new, unproven investments.

Hypothetical Example

Consider two hypothetical retail companies, Company A and Company B, both with reported operating profits of $50 million.

Company A (traditional accounting):

• Total Assets: $400 million
• Current Liabilities: $100 million
• Operating Leases (off-balance-sheet, present value equivalent): $50 million

Company B (IFRS 16 compliant):

• Total Assets (including capitalized leases): $450 million
• Current Liabilities: $100 million
• Recognized Lease Liabilities: $50 million

Calculation of Capital Employed:

• Company A (Unadjusted): $400 million - $100 million = $300 million
• Company B (Unadjusted): $450 million - $100 million = $350 million

If we were to compare their ROCE without adjustment, Company A ($50M / $300M = 16.67%) would appear more efficient than Company B ($50M / $350M = 14.29%).

Now, let's calculate an Adjusted Capital Employed Indicator for Company A to make it comparable to Company B's reporting under IFRS 16. We will capitalize Company A's off-balance-sheet operating leases:

• Company A (Adjusted Capital Employed):
  • Original Capital Employed: $300 million
  • Add capitalized operating leases: +$50 million
  • Adjusted Capital Employed: $350 million

Now, both companies have an Adjusted Capital Employed Indicator of $350 million. Using this adjusted figure, their ROCE becomes comparable:

• Company A (Adjusted ROCE): $50 million / $350 million = 14.29%
• Company B (Unadjusted/Comparable ROCE): $50 million / $350 million = 14.29%

This hypothetical example demonstrates how applying an Adjusted Capital Employed Indicator provides a more accurate basis for comparing the capital efficiency of companies with different accounting treatments for similar economic activities, like leasing. It allows for a deeper understanding of the true operational investment.

Practical Applications

The Adjusted Capital Employed Indicator has several crucial practical applications across investing, market analysis, and financial planning:

• Company Valuation: When performing company valuation multiples analysis, especially using enterprise value multiples tied to operational performance, adjusting capital employed can lead to more consistent and reliable comparisons across peer groups. Analysts often adjust financial metrics like earnings before interest, taxes, depreciation, and amortization (EBITDA) or capital employed to ensure "apples-to-apples" comparisons among similar companies. Adjustments are often necessary to account for differences in capital structure and size when applying pricing multiples derived from comparable companies.
• Performance Measurement: It enables a fairer assessment of management's effectiveness in utilizing capital by removing the impact of non-operating assets or non-standard accounting treatments. This ensures that the measured performance ratio, such as Return on Capital Employed (ROCE), genuinely reflects operational efficiency.
• Mergers and Acquisitions (M&A): In M&A due diligence, the Adjusted Capital Employed Indicator provides a clearer view of the target company's true invested capital base, assisting in more accurate valuation and synergy analysis. It helps the acquirer understand the real assets they are gaining and the associated capital requirements.
• Capital Allocation Decisions: For internal management, understanding the Adjusted Capital Employed Indicator helps in better capital allocation strategies. It provides insights into which business segments or projects are truly efficient in their use of capital, guiding future investment decisions.
• Credit Analysis: Lenders may use adjusted capital figures to assess a company's true asset base and its ability to generate returns on that base, informing their decisions regarding loan covenants and borrowing capacity.

Limitations and Criticisms

Despite its benefits, the Adjusted Capital Employed Indicator is not without its limitations and criticisms:

• Subjectivity: The primary criticism lies in the inherent subjectivity of the adjustments themselves. There is no single, universally agreed-upon list of adjustments or methods for making them. Different analysts may choose different items to adjust (e.g., whether to capitalize R&D, how to value non-operating assets), leading to varying adjusted figures for the same company.
• Complexity: Performing accurate adjustments can be complex and time-consuming, requiring detailed financial statement analysis and an understanding of a company's operations. This can be particularly challenging when information on off-balance-sheet items or detailed asset breakdowns is not readily available.
• Historical Focus: Like many accounting-based metrics, the Adjusted Capital Employed Indicator is primarily backward-looking, reflecting past capital investments. It may not fully capture a company's future prospects, strategic shifts, or the effectiveness of new, unproven capital expenditures. For instance, ROCE, a key ratio using capital employed, is criticized for being backward-looking and potentially manipulable.
• Lack of Standardization: Due to the absence of a standardized framework for adjustments, comparing Adjusted Capital Employed Indicators across different analyses or analysts can be difficult. While the goal is comparability, the varied methodologies can sometimes hinder it.
• Ignores Qualitative Factors: The indicator, being a quantitative financial metric, does not account for crucial qualitative factors such as management quality, brand strength, innovation, or competitive advantages, which significantly impact long-term value creation.

Adjusted Capital Employed Indicator vs. Capital Employed

The distinction between the Adjusted Capital Employed Indicator and standard capital employed lies in the refinement process.

In essence, standard capital employed offers a foundational view, while the Adjusted Capital Employed Indicator aims for a more nuanced and economically realistic representation, particularly vital for sophisticated investment analysis and cross-company comparisons.

FAQs

Why is an Adjusted Capital Employed Indicator necessary?

An Adjusted Capital Employed Indicator is necessary because standard accounting figures for capital employed can be distorted by various factors, such as off-balance-sheet financing (like old operating leases), significant non-operating assets, or certain accounting treatments for intangible investments. Adjusting these figures provides a more accurate and comparable measure of the capital truly utilized in a company's core operations, enabling better financial analysis and benchmarking.

What kinds of adjustments are typically made?

Typical adjustments for an Adjusted Capital Employed Indicator often include capitalizing off-balance-sheet operating leases (especially relevant before and after IFRS 16), excluding non-operating assets (like excess cash or unused property), and sometimes capitalizing historically expensed items like certain research and development or marketing costs if they are deemed long-term investments. The goal is to align the capital figure with the assets actively generating operating profits.

How does this indicator affect profitability ratios?

This indicator directly affects profitability ratios, particularly Return on Capital Employed (ROCE). By using a more accurate and comparable capital employed figure in the denominator, the resulting ROCE provides a truer reflection of a company's operational efficiency. This allows analysts to make more meaningful "apples-to-apples" comparisons of profitability across different companies or over different periods, even if they have varying accounting practices or asset structures.

Is the Adjusted Capital Employed Indicator used by all analysts?

No, the Adjusted Capital Employed Indicator is not universally used, nor are the adjustments standardized. While many professional analysts, particularly in equity research and private equity, will make similar adjustments, the specific items and methodologies can vary. This lack of standardization is one of its limitations. However, the underlying principle of seeking a more representative capital base for analysis is widely accepted in advanced financial modeling.

What is the primary benefit of using an Adjusted Capital Employed Indicator?

The primary benefit of using an Adjusted Capital Employed Indicator is its ability to enhance comparability and provide a more insightful view of a company's capital efficiency. By removing accounting noise and structural differences, it allows analysts to assess how effectively a business generates returns from the capital that is genuinely dedicated to its core operations, leading to more informed investment and strategic decisions.