Adjusted composite capital employed

What Is Adjusted Composite Capital Employed?

Adjusted Composite Capital Employed refers to a refined measure of the total capital that a company utilizes in its operations to generate profits, incorporating various adjustments to standard accounting figures to provide a more accurate representation. This metric belongs to the broader field of financial analysis, offering deeper insights into a company's operational efficiency and value creation. While the base concept of capital employed provides a foundational view of invested funds, Adjusted Composite Capital Employed seeks to eliminate distortions caused by accounting conventions and non-operating assets or liabilities, thereby reflecting the true capital base from which a company generates its operating profits. This adjusted figure is critical for investors and analysts aiming to assess a company's real profitability and capital allocation effectiveness.

History and Origin

The concept of "capital employed" as a measure of a company's invested funds has been a long-standing component of financial reporting and analysis. Traditionally, it provided a snapshot of the resources a business uses to generate profit. However, as financial transactions and corporate structures became more complex, and accounting standards evolved, the need for adjustments to this raw figure became apparent. The push for a more "adjusted" or "invested" capital figure gained significant traction with the advent of more sophisticated valuation methodologies, particularly those focusing on economic profit and a company's ability to earn returns above its cost of capital.

A major development influencing the adjustment of capital employed metrics was the introduction of International Financial Reporting Standard 16 (IFRS 16), which came into effect for annual reporting periods beginning on or after January 1, 2019. This standard fundamentally changed how companies account for operating leases, requiring most leases to be recognized on the balance sheet as right-of-use assets and corresponding lease liabilities.²⁸, ²⁹ Prior to IFRS 16, many operating leases were off-balance-sheet, meaning the capital effectively employed through leased assets was not fully reflected in traditional capital employed calculations.²⁶, ²⁷ The changes brought by IFRS 16 necessitated adjustments to correctly capture all capital utilized. Beyond regulatory changes, financial thinkers and analysts, such as Michael Mauboussin, have long advocated for a more comprehensive and adjusted view of invested capital to better assess a company's value creation. Mauboussin's extensive work emphasizes that reported accounting numbers often need significant adjustments to reflect the true economic capital employed in a business, especially concerning items like intangible assets and non-operating items.²⁴, ²⁵

Key Takeaways

• Adjusted Composite Capital Employed offers a more accurate measure of the capital a company truly uses to generate operating profits.
• It goes beyond traditional capital employed by making specific adjustments for accounting distortions and non-operating items.
• Key adjustments often include accounting for operating leases, excess cash, and certain intangible assets.
• This metric is crucial for calculating profitability financial ratios like Return on Invested Capital (ROIC) to gain a clearer picture of efficiency.
• Understanding Adjusted Composite Capital Employed aids in better valuation and capital allocation decisions.

Formula and Calculation

While there isn't one universal formula for "Adjusted Composite Capital Employed," it generally begins with a standard measure of capital employed and then incorporates specific adjustments. The base capital employed can be calculated in several ways, often as:

Alternatively, it can be viewed from the financing side:

To arrive at "Adjusted Composite Capital Employed," analysts make several critical adjustments to these base figures, aiming to capture only the capital directly used in core operations. These adjustments typically include:

• Adding back operating lease liabilities: Under IFRS 16, these are now on the balance sheet, but for consistent historical comparison or specific analytical needs, their capital equivalent may be added if not already fully captured. This ensures that assets obtained through leases are reflected in the capital base.²², ²³
• Subtracting excess cash and marketable securities: Cash held beyond operational needs is considered a non-operating asset and is thus removed to reflect only the capital actively employed in the business.²⁰, ²¹
• Adding back certain intangible investments: Historically expensed items like research and development (R&D) or significant brand-building expenses, which create long-term value but are not fully capitalized on the financial statements, may be "re-capitalized" for a more complete picture of invested capital. This helps recognize the capital invested in these critical growth drivers.¹⁸, ¹⁹
• Adjusting for accumulated depreciation or asset write-downs: Some analyses add back accumulated depreciation or asset write-downs (after-tax) to reflect the historical investment base more accurately rather than its depreciated book value.¹⁶, ¹⁷
• Consideration of goodwill from acquisitions: While goodwill is often included, its treatment can be adjusted to reflect core operating capital more precisely, depending on whether it truly represents operating assets or simply an acquisition premium.¹⁴, ¹⁵

The precise formula for Adjusted Composite Capital Employed is thus a customized one, built upon these common adjustments to the company's reported balance sheet and income statement figures. The goal is to provide a cleaner, more economically meaningful denominator for performance metrics.

Interpreting the Adjusted Composite Capital Employed

Interpreting the Adjusted Composite Capital Employed figure is not about its absolute value, but rather how it is used in conjunction with profitability measures to assess a company's efficiency. A carefully calculated Adjusted Composite Capital Employed figure serves as the denominator in key efficiency metrics, most notably Return on Invested Capital (ROIC). By using an adjusted figure, analysts can gain a truer understanding of how effectively a company is converting its invested capital into operating profits.

For instance, a higher ROIC calculated with Adjusted Composite Capital Employed suggests that the company is more efficient at generating profits from all the capital it truly employs, including off-balance-sheet items and economically relevant intangible investments. This allows for more meaningful comparisons between companies, especially those with different capital structures or accounting policies for assets like leases or R&D. When evaluating this metric, it's important to consider industry averages and a company's historical trends, as capital intensity varies significantly across sectors. Comparing Adjusted Composite Capital Employed, and subsequently ROIC, against the company's weighted average cost of capital (WACC) helps determine if the company is creating positive economic profit—that is, earning returns greater than the cost of funding its operations.

Hypothetical Example

Consider "Tech Innovations Inc.," a software company, and "Manufacturing Giant Co.," a traditional industrial firm.

Manufacturing Giant Co.'s Initial Capital Employed:

• Total Assets: $500 million
• Current Liabilities: $100 million
• Capital Employed (Traditional) = $500M - $100M = $400 million

Tech Innovations Inc.'s Initial Capital Employed:

• Total Assets: $200 million
• Current Liabilities: $50 million
• Capital Employed (Traditional) = $200M - $50M = $150 million

Now, let's introduce adjustments for "Adjusted Composite Capital Employed":

Manufacturing Giant Co. Adjustments:

• Operating Lease Liabilities (pre-IFRS 16, now recognized or conceptually added back): $30 million (representing the present value of future lease payments for its factories and equipment)
• Excess Cash: $5 million (cash not needed for daily operations)

Adjusted Composite Capital Employed for Manufacturing Giant Co.:
$400M (Traditional CE) + $30M (Leases) - $5M (Excess Cash) = $425 million

Tech Innovations Inc. Adjustments:

• Excess Cash: $20 million (from recent funding rounds, not yet deployed)
• Capitalized R&D (an analyst adjustment, assuming $40 million in R&D over several years that created significant intangible value, but was expensed): $40 million

Adjusted Composite Capital Employed for Tech Innovations Inc.:
$150M (Traditional CE) - $20M (Excess Cash) + $40M (Capitalized R&D) = $170 million

By calculating the Adjusted Composite Capital Employed, we get a more accurate view of the capital each company genuinely employs to generate its operating profits. For instance, if both companies generated $50 million in Net Operating Profit After Tax (NOPAT), their unadjusted ROIC would be Manufacturing Giant Co. ($50M/$400M = 12.5%) and Tech Innovations Inc. ($50M/$150M = 33.3%). However, with Adjusted Composite Capital Employed, their ROIC would be Manufacturing Giant Co. ($50M/$425M = 11.76%) and Tech Innovations Inc. ($50M/$170M = 29.4%). This illustrates how adjustments can subtly, yet meaningfully, alter the perceived efficiency of a company's capital usage.

Practical Applications

Adjusted Composite Capital Employed is a vital metric across several areas of finance and investment analysis. Its primary application lies in enhancing the accuracy of profitability analysis, particularly when calculating metrics such as Return on Invested Capital (ROIC). By using an adjusted figure, investors and analysts can compare companies more consistently, even if they operate with different accounting policies (e.g., regarding leases or the capitalization of certain expenditures) or industry structures.

In corporate finance, management teams use Adjusted Composite Capital Employed to evaluate the efficiency of their internal investments and capital allocation decisions. It helps in identifying whether projects or divisions are generating sufficient returns on the true capital deployed. For instance, if a company leases a significant amount of its property, machinery, or equipment, the inclusion of these operating leases in the Adjusted Composite Capital Employed provides a more complete picture of the resources underpinning the business's operations. This is particularly relevant given the post-IFRS 16 accounting environment, which brought many of these leases onto the balance sheet, reflecting their impact on a company's financial leverage and capital employed. T¹², ¹³he International Monetary Fund (IMF) also provides insights into global economic and corporate investment trends, underscoring the importance of accurate capital assessment for broader economic stability and growth analysis.

¹¹For valuation purposes, analysts employing discounted cash flow (DCF) models or economic profit frameworks often rely on an Adjusted Composite Capital Employed figure. This helps in projecting future free cash flows more accurately by ensuring that the capital base generating those cash flows is correctly represented. Furthermore, regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC), require publicly traded companies to file comprehensive financial statements and disclosures. W⁹, ¹⁰hile the SEC does not mandate a specific "Adjusted Composite Capital Employed" calculation, the underlying principle of transparent and economically sound financial reporting supports the rationale behind making such adjustments for internal analysis or investor communication.

Limitations and Criticisms

While Adjusted Composite Capital Employed offers a more refined view of a company's capital base, it is not without limitations. One primary criticism is the subjective nature of some adjustments. Deciding which items constitute "excess" cash, the appropriate capitalization of R&D or other intangible investments, or the precise value of off-balance-sheet items often requires significant judgment and can vary among analysts. This subjectivity can lead to different interpretations of a company's Adjusted Composite Capital Employed and, consequently, its profitability metrics like ROIC.

⁸Another limitation stems from the inherent reliance on historical financial data. Adjusted Composite Capital Employed, like other backward-looking financial ratios, reflects past investments. It may not fully capture the impact of recent strategic shifts, future growth prospects, or evolving industry dynamics. F⁶, ⁷or example, a company making large, long-term investments that are yet to yield significant returns might show a lower Adjusted Composite Capital Employed-derived ROIC in the short term, even if those investments are expected to create substantial value in the future.

⁵Furthermore, the complexity involved in making these adjustments can be a barrier for some users. Gathering the necessary detailed information from financial statements and applying consistent methodologies across different companies or over time can be challenging. Despite the efforts to standardize financial reporting through frameworks like IFRS, variations in how companies disclose or classify certain items can complicate the calculation of a truly "composite" and comparable adjusted capital figure. Michael Mauboussin and Dan Callahan acknowledge these practical challenges in their work on ROIC, highlighting the need for careful consideration when making these adjustments. C⁴ritics also point out that focusing solely on capital efficiency metrics, even adjusted ones, might overlook other crucial aspects of a company's health, such as market positioning, competitive advantages, or innovation potential.

Adjusted Composite Capital Employed vs. Invested Capital

Adjusted Composite Capital Employed and Invested Capital are closely related terms, often used interchangeably, but "Adjusted Composite Capital Employed" implies a more thorough and deliberate process of refining the "Invested Capital" figure for analytical purposes.

• Invested Capital: This is a broad term representing the total amount of capital a company has used to finance its operations, including both debt and equity. It can be calculated simply from the balance sheet as total assets minus current liabilities, or as the sum of shareholders' equity and long-term debt. I¹, ², ³t aims to show the capital base from which a company generates its operating income.
• Adjusted Composite Capital Employed: This term emphasizes the process of making specific adjustments to the standard Invested Capital figure. The "adjusted" aspect refers to stripping out non-operating assets (like excess cash) and adding in off-balance-sheet operating liabilities (like certain operating leases before IFRS 16, or their economic equivalents post-IFRS 16), and re-capitalizing certain expensed intangible investments. The "composite" aspect suggests a comprehensive view that consolidates all economically relevant capital, irrespective of its accounting treatment. The goal of these adjustments is to provide a more accurate and consistent representation of the true operating capital used to generate a company's core profits, making it a more robust denominator for calculating profitability ratios like Return on Invested Capital (ROIC).

In essence, Adjusted Composite Capital Employed is a refined version of Invested Capital, specifically tailored to provide a cleaner measure for performance evaluation and valuation models by removing accounting artifacts that obscure the true operational capital base.

FAQs

What is the main purpose of calculating Adjusted Composite Capital Employed?
The main purpose is to gain a more accurate understanding of the total capital truly invested in a company's core operations. By making adjustments for accounting conventions and non-operating items, it provides a clearer picture of how efficiently a company is utilizing its resources to generate profits, particularly useful for calculating Return on Invested Capital (ROIC).

Why are adjustments like excess cash or operating leases important?
Adjustments for items like excess cash and operating leases are crucial because they ensure that only the capital directly contributing to a company's operating profits is included. Excess cash is non-operating, and including it would artificially inflate the capital base, making the company appear less efficient. Similarly, operating leases, which provide assets vital for operations, should be reflected as part of the capital employed, especially with the changes introduced by IFRS 16.

Does Adjusted Composite Capital Employed have a standard formula?
No, there isn't a single, universally standardized formula for Adjusted Composite Capital Employed. It is a concept that involves making various analytical adjustments to a company's reported financial statements. The specific adjustments can vary depending on the analyst's objective and the industry in question, but commonly include correcting for operating leases, excess cash, and certain intangible investments.

How does Adjusted Composite Capital Employed relate to company valuation?
Adjusted Composite Capital Employed is a critical input for various valuation methodologies, especially those that focus on a company's ability to generate returns on its capital. By providing a more accurate denominator for profitability ratios, it helps analysts make more reliable projections of a company's future cash flows and assess its intrinsic value. A precise Adjusted Composite Capital Employed figure enhances the credibility of financial models and investment analyses.

Can Adjusted Composite Capital Employed be used for comparing companies across different industries?
While Adjusted Composite Capital Employed aims to provide a more comparable measure of capital, direct comparisons across vastly different industries should still be made with caution. Industries inherently have different capital structures and asset intensities. However, within the same industry or for companies with similar business models, the Adjusted Composite Capital Employed figure facilitates more meaningful peer analysis than unadjusted capital employed.