Capital employed and invested capital

So far in our analysis we have looked at inflows and outflows, or revenues and costs during a given period. We will now temporarily set aside this dynamic approach and place ourselves at the end of the period (rather than considering changes over a given period) and analyse the balances outstanding.

For instance, in addition to changes in net debt over a period we also need to analyse net debt at a given point in time. Likewise, we will study here the wealth that has been accumulated up to a given point in time, rather than that generated over a period. The balance represents a snapshot of the cumulative inflows and outflows previously generated by the business.

To summarise, we can make the following connections:

• an inflow or outflow represents a change in ‘‘stock’’; i.e., in the balance outstanding;
• a ‘‘stock’’ is the arithmetic sum of inflows and outflows since a given date (when the business started up) through to a given point in time. For instance, at any moment shareholders’ equity is equal to the sum of capital increases by shareholders and annual net income for past years not distributed in the form of dividends plus the original share capital.

Main items on a balance sheet

Assets on the balance sheet comprise:

• fixed assets; i.e., everything required for the operating cycle that is not destroyed as part of it. These items retain some value (any loss in their value is accounted for through depreciation, amortisation and impairment losses). A distinction is drawn between tangible fixed assets (land, buildings, machinery, etc.1), intangible fixed assets (brands, patents, goodwill, etc.) and investments. When a business holds shares in another company (in the long term), they are accounted for under investments;
• inventories and trade receivables; i.e., temporary assets created as part of the operating cycle;
• lastly, marketable securities and cash that belong to the company and are thus assets.

Inventories, receivables, marketable securities and cash represent the current assets, a term reflecting the fact that these assets tend to ‘‘turn over’’ during the operating cycle. Resources on the balance sheet comprise:

• capital provided by shareholders, plus retained earnings, known as shareholders’ equity;
• borrowings of any kind that the business may have arranged – e.g., bank loans, supplier credits, etc. – known as liabilities.

By definition, a company’s assets and resources must be exactly equal. This is the fundamental principle of double-entry accounting.

When an item is purchased, it is either capitalised or expensed. If it is capitalised, it will appear on the asset side of the balance sheet, and, if expensed, it will lead to a reduction in earnings and thus shareholders’ equity. The double-entry for this purchase is either a reduction in cash (i.e., a decrease in an asset) or a commitment (i.e., a liability) to the vendor (i.e., an increase in a liability). According to the algebra of accounting, assets and resources (equity and liabilities) always carry the opposite sign, so the equilibrium of the balance sheet is always maintained.

It is European practice to classify assets starting with fixed assets and to end with cash, whereas it is North American and Japanese practice to start with cash. The same is true for the equity and liabilities side of the balance sheet: Europeans start with equity, whereas North Americans and the Japanese end with it.

Fixed assets

These represent all the investments carried out by the business, based on our financial and accounting definition.

It is helpful to distinguish wherever possible between operating and nonoperating assets that have nothing to do with the company’s business activities; e.g., land, buildings and subsidiaries active in significantly different or noncore businesses. Nonoperating assets can thus be excluded from the company’s capital employed. By isolating nonoperating assets, we can assess the resources the company may be able to call upon in hard times (i.e., through the disposal of nonoperating assets).

The difference between operating and nonoperating assets can be subtle in certain circumstances. For instance, how should a company’s head office on Bond Street or on the Champs-Elyse´es be classified? Probably under operating assets for a fashion house or a car manufacturer, but under nonoperating assets for an engineering or construction group which has no business reason to be on Bond Street, unlike Burberry or Jaguar.