concept of capital employed

5.4.1 The Main Elements of a Statement of Financial Position (Balance Sheet)

Learning Objectives

• Identify and correctly classify assets, liabilities and equity on a statement of financial position.
• Explain, using the exact Cambridge terminology, how capital employed is derived – both the asset‑side and the financing‑side approaches.
• Interpret a simple statement of financial position to comment on:
  • the business’s financing mix (proportion of equity versus long‑term debt),
  • short‑term liquidity (current ratio), and
  • the basis for the ROCE ratio.

What is a Statement of Financial Position?

The statement of financial position (SFP) records a business’s financial position at a single point in time. It shows the three main elements required by the Cambridge syllabus:

• Assets – resources owned or controlled that are expected to generate future economic benefit.
• Liabilities – present obligations that will require an outflow of resources.
• Equity – the residual interest of the owners after all liabilities have been deducted from assets.

Classification of Assets

Category (Cambridge wording)	Definition	Typical Examples
Non‑current assets (long‑term assets)	Resources expected to be used by the business for **more than 12 months**.	Land & buildings, plant & machinery, patents, long‑term investments.
Current assets	Resources expected to be realised (converted into cash) or consumed **within 12 months**.	Cash, inventory, trade receivables, short‑term investments.

Classification of Liabilities

Category (Cambridge wording)	Definition	Typical Examples
Non‑current liabilities	Obligations that are **not due for settlement within the next 12 months**.	Long‑term bank loan, bonds payable, finance‑lease obligations.
Current liabilities	Obligations that are **expected to be settled within the next 12 months**.	Trade payables, short‑term borrowings, taxes payable, accrued expenses.

Components of Equity

Equity is presented as a separate third element on the SFP. The Cambridge syllabus expects the following headings (any of which may be zero for a small firm):

• Share capital (paid‑in capital) – money invested by the owners when shares are issued.
• Retained earnings – accumulated profits that have not been distributed as dividends.
• Other reserves (e.g., revaluation reserve, share‑premium reserve) – may be shown if applicable.

Typical Layout of a Statement of Financial Position

Statement of Financial Position (as at 31 December 20XX)
Assets
Non‑current assets	£ XXX,XXX
Current assets	£ YYY,YYY
Liabilities
Non‑current liabilities	£ ZZZ,ZZZ
Current liabilities	£ AAA,AAA
Equity
Share capital	£ BBB,BBB
Retained earnings	£ CCC,CCC
Other reserves (if any)	£ DDD,DDD

Concept of Capital Employed

Capital employed is the total amount of capital that is used to generate the business’s profits. The Cambridge syllabus states the definition in two equivalent ways:

1. Asset‑side approach $$\text{Capital Employed}= \text{Total Assets} - \text{Current Liabilities}$$
2. Financing‑side approach $$\text{Capital Employed}= \text{Equity} + \text{Non‑current Liabilities}$$

Both formulas give the same result because of the fundamental accounting equation:

$$\text{Total Assets}= \text{Equity} + \text{Non‑current Liabilities} + \text{Current Liabilities}$$

Why Capital Employed Matters

• It shows the amount of **long‑term financing** that is actually being used in the business.
• It is the denominator in the Return on Capital Employed (ROCE) ratio – a key indicator of profitability and efficiency.
• It helps managers assess whether resources are being deployed effectively.

Example Calculation

Assume the following figures are extracted from the SFP above:

• Total assets = £ 500,000
• Current liabilities = £ 80,000
• Equity = £ 250,000
• Non‑current liabilities = £ 170,000

Using the asset‑side formula:

$$\text{Capital Employed}= 500,000 - 80,000 = £ 420,000$$

Using the financing‑side formula:

$$\text{Capital Employed}= 250,000 + 170,000 = £ 420,000$$

Both methods give the same capital employed of **£ 420,000**.

Interpreting a Simple Statement of Financial Position

1. Financing Mix (Equity vs Long‑term Debt)

Calculate the proportion of long‑term financing:

$$\frac{\text{Equity} + \text{Non‑current Liabilities}}{\text{Total Assets}} \times 100\%$$

Using the example:

$$\frac{250,000 + 170,000}{500,000}\times100 = 84\%$$

A high proportion of equity (e.g., > 70 %) usually indicates lower financial risk because the business relies less on borrowed funds.

2. Short‑term Liquidity

Two common measures:

• Current assets – Current liabilities (a simple cash‑flow test).
• Current ratio $$\text{Current Ratio}= \frac{\text{Current Assets}}{\text{Current Liabilities}}$$

Assume Current assets = £ 120,000 and Current liabilities = £ 80,000:

• Current assets – Current liabilities = £ 40,000 (positive → can meet short‑term obligations).
• Current ratio = 120,000 ÷ 80,000 = **1.5** (values > 1.0 are generally satisfactory).

3. Profitability – Using ROCE

If the exam question gives a ROCE of 12 %:

$$\text{ROCE}= \frac{\text{Profit before interest and tax (PBIT)}}{\text{Capital Employed}}$$ $$\text{PBIT}= \text{ROCE} \times \text{Capital Employed}=0.12 \times 420,000 = £ 50,400$$

4. Sample Exam‑style Questions

1. What proportion of the business’s total financing is long‑term?
   Answer: 84 % (see calculation above).
2. Comment on the business’s short‑term liquidity.
   Answer: Current assets exceed current liabilities by £ 40,000 and the current ratio is 1.5, indicating a comfortable liquidity position.
3. If ROCE is 12 %, calculate the profit before interest and tax.
   Answer: £ 50,400 (see calculation above).
4. What does a high proportion of equity suggest about the business’s risk profile?
   Answer: It suggests lower financial risk because the owners have provided most of the long‑term funding, reducing reliance on interest‑bearing debt.

Key Summary Points

• Accounting equation: Assets = Liabilities + Equity.
• Current items are those expected to be realised or settled **within 12 months**; non‑current items extend **beyond 12 months**.
• Capital employed can be expressed as:
  • Asset‑side: Total assets – Current liabilities
  • Financing‑side: Equity + Non‑current liabilities
• Capital employed is the denominator of the **ROCE** ratio, which measures how efficiently a business uses its long‑term financing.
• When analysing a statement of financial position, look at:
  • Financing mix – proportion of equity versus long‑term debt.
  • Short‑term liquidity – current assets vs current liabilities (current ratio).
  • Profitability – calculate ROCE or use a given ROCE to find PBIT.