Definition of capital employed

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Guest

Guest (Querist)

11 November 2014 Dear expert,
as per shareholders fund approach , capital employed means Total assets minus non trading assets minus miscellaneous expenditure and losses minus all outside liabilities.
IT has 2 shortcomings: which i m not able to understand
1. it ignores other long term funds in the business.
2. on the other hand , it considers preference share capital which bears fixed rate of dividend.
QUERY : PLEASE EXPLAIN SHORTCOMINGS OF THIS APPROACH..

Amol S Joglekar

Amol S Joglekar (Expert)
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11 November 2014 Finance has always been construed as REFERENCE to CONTEXT kind of subject. Obviously the approach may get changed from time to time and even person to person.
As an examinee, one needs to recite these various approaches as they are AND as practioneer, one needs to write the assumption made in calculating the capital employed.

Guest

Guest (Querist)

12 November 2014 sir i want u to throw some light on its shortcomings... i m not able to relate them properly... i want to get good hold on this since this para is of study material.

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Asha Kanta Sharma

Asha Kanta Sharma

(Expert)
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20 July 2024 The definition of capital employed based on the shareholders' fund approach focuses primarily on equity shareholders' interests in the business. However, this approach has two key shortcomings:

1. **Ignores Other Long-Term Funds:**
- In business finance, capital can come from sources other than equity shareholders' funds. These sources include long-term debt, reserves, and retained earnings. By focusing only on shareholders' funds (equity), the shareholders' fund approach ignores the financial contributions and commitments made by these other sources of capital.
- This omission can lead to an incomplete picture of the total financial resources available to the business. For instance, long-term debt such as loans or debentures represents an important source of funds that are committed to the business over the long term but are not captured under shareholders' funds alone.

2. **Treatment of Preference Share Capital:**
- Preference share capital is considered a part of shareholders' funds because it represents an ownership interest in the company. However, preference shares typically carry fixed dividend rates that must be paid out to shareholders before dividends can be paid to equity shareholders.
- Including preference share capital in the definition of capital employed can distort the calculation of returns on equity (ROE) metrics. Preference shares have different characteristics compared to equity shares, and their inclusion can mask the true return generated by equity shareholders.

**Implications:**
- By excluding other long-term funds and including preference share capital, the shareholders' fund approach to defining capital employed can lead to an incomplete assessment of the total funds available for the business and the returns generated specifically for equity shareholders.
- Financial analysts and investors often use adjusted measures of capital employed that include all long-term funds (both equity and debt) to gain a more comprehensive view of a company's financial structure and performance.

In summary, while the shareholders' fund approach provides a straightforward calculation method, it may not fully reflect the total financial resources and commitments of a business due to its limitations in recognizing other long-term funds and the unique characteristics of preference share capital.

Amol S Joglekar

Amol S Joglekar (Expert)
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21 July 2024 The short comings cited above are important to note.