Adjusted free capital employed

What Is Adjusted Free Capital Employed?

Adjusted Free Capital Employed (AFCE) is a financial metric that refines the traditional concept of capital employed to better reflect the true economic capital utilized by a business in its operations. It belongs to the broader category of financial performance measurement, aiming to provide a more accurate view of capital efficiency and value creation by making specific adjustments to reported accounting figures. While standard capital employed typically represents the total investment a company uses to generate profits, AFCE goes further by correcting for various non-cash or non-operational items that can distort the reported capital base. This adjusted figure offers deeper insights into how effectively a company's investment decisions contribute to its overall profitability and shareholder value. Unlike raw accounting numbers, Adjusted Free Capital Employed seeks to align capital measurement with the actual economic resources deployed.

History and Origin

The concept of adjusting accounting figures to derive a more "economic" view of performance gained prominence with the rise of value-based management philosophies in the late 20th century. A significant driver was the popularization of Economic Value Added (EVA) by the consulting firm Stern Stewart in the early 1990s. Joel Stern and G. Bennett Stewart III were key figures in advancing this framework, arguing that traditional accounting profits often failed to capture the true economic value created by a company because they did not adequately account for the cost of capital or certain capital expenditures.⁸, ⁹, ¹⁰, ¹¹

Stern Stewart advocated for numerous adjustments to both net operating profit after taxes (NOPAT) and capital employed to arrive at a more economically sound measure. These adjustments were intended to convert financial statements from an accrual accounting basis to a cash basis and to capitalize investments that provide long-term benefits but are expensed in traditional accounting. The focus was on identifying the "true" capital base on which a company should earn a return above its cost of funding. This intellectual lineage forms the foundation for what is termed Adjusted Free Capital Employed, emphasizing a more refined view of capital.

Key Takeaways

• Adjusted Free Capital Employed (AFCE) refines traditional capital employed by accounting for non-cash or non-operational items, providing a more accurate measure of economic capital.
• It is a key metric in financial analysis that helps assess a company's true capital efficiency and its ability to generate returns above its cost of funding.
• AFCE calculations often involve adjustments to figures found on the balance sheet and income statement, such as capitalizing R&D or adjusting for provisions.
• A positive trend in AFCE, when compared to a company's return, indicates that the business is effectively utilizing its capital to create economic value.
• Understanding AFCE is crucial for investors and management in making informed decisions regarding capital allocation and evaluating long-term performance.

Formula and Calculation

The calculation of Adjusted Free Capital Employed typically starts with the standard definition of capital employed and then incorporates specific adjustments. While there isn't one universal "Adjusted Free Capital Employed" formula, it fundamentally builds upon the concept of capital employed (total assets minus current liabilities, or fixed assets plus working capital) and then applies adjustments similar to those made in calculating economic profit or EVA.

A simplified conceptual approach to deriving Adjusted Free Capital Employed often involves:

Where:

• Total Assets represents the company's total assets as reported on its balance sheet.
• Current Liabilities are short-term financial obligations due within one year.
• Adjustments are modifications made to the reported capital to reflect a more accurate economic capital base. These can include:
  • Capitalization of certain expenses: Adding back expenses like research and development (R&D), advertising, or employee training that are expensed but create long-term value.
  • Adjustments for provisions and allowances: Reversing the impact of non-cash provisions or allowances for doubtful debts.
  • Treatment of operating leases: Capitalizing operating leases as assets and liabilities to reflect their economic substance.

Alternatively, some derivations might start with a measure like Net Operating Profit After Tax (NOPAT) and work backward to infer the capital base required to generate that profit, incorporating similar adjustments to the asset base.

Interpreting the Adjusted Free Capital Employed

Interpreting Adjusted Free Capital Employed involves understanding what the refined capital figure signifies about a company's operational efficiency and value creation. A company with a stable or growing Adjusted Free Capital Employed figure, combined with strong returns, suggests effective utilization of its economic resources. This metric helps analysts and managers evaluate how well a business generates returns relative to the actual capital invested in its operations, rather than just its reported book value. It provides a more realistic view of the capital base that is actively generating economic profits.

For instance, a company might show a lower traditional Return on Capital Employed (ROCE) if it has significant investments in intangible assets like brand development or R&D that are expensed rather than capitalized. By adjusting for these, Adjusted Free Capital Employed can reveal a higher, more accurate capital base that is indeed generating substantial returns, thereby improving the perceived efficiency of management's capital expenditures.

Hypothetical Example

Consider "InnovateTech Inc.", a software development company. For the past year, InnovateTech reports:

• Total Assets: $50 million
• Current Liabilities: $10 million
• R&D Expenses (expensed in income statement): $5 million (considered value-creating over 5 years)
• Advertising Expenses (expensed in income statement): $2 million (considered value-creating over 3 years)

Step 1: Calculate traditional Capital Employed.
Capital Employed = Total Assets – Current Liabilities
Capital Employed = $50 million – $10 million = $40 million

Step 2: Determine adjustments for Adjusted Free Capital Employed.
InnovateTech's R&D and advertising expenses, while expensed, are considered long-term investments in building future value. For simplicity, assume that for AFCE, 80% of current year's R&D and 50% of current year's advertising are deemed capitalizable for economic purposes.

• Capitalized R&D adjustment: $5 million * 0.80 = $4 million
• Capitalized Advertising adjustment: $2 million * 0.50 = $1 million

Step 3: Calculate Adjusted Free Capital Employed.
Adjusted Free Capital Employed = Traditional Capital Employed + Capitalized R&D adjustment + Capitalized Advertising adjustment
Adjusted Free Capital Employed = $40 million + $4 million + $1 million = $45 million

In this scenario, InnovateTech's Adjusted Free Capital Employed of $45 million provides a more comprehensive view of the capital actually generating economic returns, as it includes the long-term benefit-generating aspects of R&D and advertising that are typically expensed. This figure would then be used in conjunction with economically adjusted profits to assess the company's true financial health.

Practical Applications

Adjusted Free Capital Employed finds practical application in several areas of finance and corporate strategy, particularly within the field of corporate finance.

1. Performance Evaluation: Companies use AFCE to assess the true profitability and efficiency of their operations. By adjusting for accounting distortions, management can gain a clearer picture of which business units or projects are effectively generating returns above their true capital cost. This aids in better internal resource allocation.
2. ⁷ Valuation and Investment Decisions: Investors and analysts often consider AFCE when performing company valuations, especially when using models like discounted economic profit. This provides a more robust measure of the capital base, leading to more accurate valuations and informed investment decisions.
3. Capital Allocation Strategy: AFCE can inform a company's capital allocation framework by providing a refined understanding of the capital base that requires a return. This helps executives prioritize investments, whether it's reinvesting in existing operations, funding new projects, or returning capital to shareholders. The importance of proper capital allocation for maximizing shareholder profits is well-documented.
4. ⁶ Incentive Compensation: Tying management compensation to metrics derived from Adjusted Free Capital Employed or similar economic profit measures can align managerial incentives with long-term value creation. This encourages managers to make decisions that truly enhance economic performance rather than merely boosting short-term accounting profits.
5. Regulatory Scrutiny: While not a direct regulatory metric, the principles behind AFCE—adjusting accounting data to reflect economic reality—are implicitly relevant in how regulators assess the underlying strength and capital adequacy of financial institutions. Information reported to the U.S. Securities and Exchange Commission (SEC) via the EDGAR database can be used by analysts to derive such adjusted figures.

Limitations and Criticisms

Despite its theoretical advantages in providing a more economically accurate view of capital, Adjusted Free Capital Employed, like any complex financial metric, has its limitations and faces criticisms.

One primary challenge is the subjectivity of adjustments. There is no universal standard for what constitutes a necessary "adjustment" or how to quantify its impact on capital employed. Different analysts or companies may make varying assumptions regarding the capitalization of expenses like research and development or marketing, leading to inconsistencies. For instance, determining the "economic depreciation" of an asset versus its accounting depreciation can be highly judgmental. This la³, ⁴, ⁵ck of standardization can make it difficult to compare AFCE across different companies or even over time for the same company if adjustment methodologies change.

Another limitation is the complexity and data requirements. Calculating AFCE often necessitates detailed financial data and a deep understanding of a company's operations to identify and quantify all relevant adjustments. This can be particularly challenging for external analysts who rely solely on publicly available financial statements and may not have access to the granular internal data required for comprehensive adjustments.

Furthermore, focusing too heavily on a single metric, even an adjusted one, can potentially lead to short-term managerial behavior if not carefully implemented. While the intent of AFCE is to foster long-term value creation, managers whose incentives are tied to an adjusted metric might still find ways to manipulate or optimize reported figures rather than genuinely improving operational efficiency. Some critiques of similar economic profit measures highlight that they can, in certain contexts, encourage underinvestment in projects that might reduce short-term cash flow but create significant long-term value. Even we²ll-intentioned adjustments can introduce new biases or make the metric less intuitive for stakeholders.

Adjusted Free Capital Employed vs. Economic Value Added

Adjusted Free Capital Employed (AFCE) and Economic Value Added (EVA) are closely related concepts within the realm of economic profit and value-based management. Often, AFCE can be seen as a key component or input into the calculation of EVA.

The fundamental difference lies in their primary focus:

• Adjusted Free Capital Employed (AFCE) focuses on the capital base. It aims to determine the true economic capital that a company employs in its operations by making various adjustments to standard accounting capital figures. The output is a refined measure of the capital invested.
• Economic Value Added (EVA), on the other hand, is a profitability measure. It quantifies the surplus value created by a company in excess of the return required by its investors. EVA is calculated as NOPAT minus a capital charge, where the capital charge is the product of Adjusted Free Capital Employed (or a similar "invested capital" figure) and the weighted average cost of capital (WACC).

In essence, EVA uses an adjusted capital figure (which is synonymous with or very similar to AFCE) to determine if a company is generating returns that sufficiently compensate all its capital providers, both debt and equity. AFCE provides the 'denominator' of the capital charge within the EVA calculation. While EVA explicitly includes the opportunity cost of invested capital, free cash flow does not directly deduct the cost of capital. Therefo¹re, understanding AFCE is crucial for accurately calculating and interpreting EVA.

FAQs

What are common adjustments made to calculate Adjusted Free Capital Employed?

Common adjustments often involve capitalizing expenses that have long-term benefits but are typically expensed in accounting, such as research and development (R&D) costs and significant advertising outlays. Other adjustments may include reclassifying operating leases as finance leases on the balance sheet, and adjusting for certain non-cash provisions or deferred taxes to reflect the true economic capital.

Why is Adjusted Free Capital Employed considered more "economic" than traditional capital employed?

Adjusted Free Capital Employed is considered more "economic" because it attempts to correct for distortions introduced by traditional accounting principles. Standard accounting rules may expense certain investments (like R&D) that, from an economic perspective, build long-term assets and should be capitalized. By making these adjustments, AFCE aims to reflect the full amount of capital genuinely employed to generate future economic benefits and profits.

How does Adjusted Free Capital Employed relate to value creation?

Adjusted Free Capital Employed is directly related to value creation by providing a more accurate base against which a company's returns can be measured. When a company consistently generates a return on its Adjusted Free Capital Employed that exceeds its cost of capital, it indicates that the company is creating economic value for its shareholders. This metric helps identify whether a business is truly profitable after accounting for the full cost of all capital used.