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Return on Total Capital

Assessing a business' use of its capital structure

What is Return on Total Capital?

Return on Total Capital (ROTC) is a return on investment ratio that quantifies how much return a company has generated through the use of its capital structure. This ratio is different from return on common equity (ROCE) as the former quantifies the return a company has made on its common equity investment. The ROCE figure can be misleading, as it does not take into account a company’s use of debt. A company that employs a large amount of debt in its capital structure will have a high ROCE.

 

Return on Total Capital

 

ROTC gives a fairer assessment of the company’s use of funds to finance its projects and functions better as an overall profitability metric. This ratio is immune from artificial inflation induced by a capital structure that employs a significantly higher or lower amount of debt capital than equity capital.

Return on Total Capital can be used to evaluate how well a company’s management has utilized its capital structure to generate value for both equity and debt holders. ROTC is a better measure to assess management’s abilities than the ROCE ratio since the latter only monitors management’s use of common equity capital.

 

How to Calculate Return on Total Capital

Return on Total Capital can be calculated using the formula below:

 

Return on Total Capital - Formula
Expressed as a percentage

 

Where:

Earnings Before Interest & Taxes (EBIT) – Represents profit that the business has realized, without the inclusion of interest or tax payments

Total Capital – Refers to the business’ total available capital, calculated as Total Capital = Short Term Debt + Long Term Debt + Shareholder’s Equity

In the case of a business that has no liabilities outside of short-term debt, long-term debt, and total equity, return on total capital is virtually identical to the return on assets (ROA) ratio. This is because the business’ capital structure would make up the entirety of the business’ liability section on its balance sheet. That figure would be equal to the business’ total assets. (Assets = Liabilities + Equity).

While ROA is also a useful profitability metric, it takes a more reactive approach to computing a business’ use of capital. ROA measures the value a business is able to generate based on the assets it employs, rather than on capital allocation decisions.

 

Return on Total Capital Example

Mark’s Doughnuts wants to assess how well it has deployed its capital structure by calculating the ROTC of the business for the past few years. Below are the business’ financial statements for the past few years:

 

Return on Total Capital Example - IS
From CFI’s Income Statement Template

 

Return on Total Capital Example - BS
From CFI’s Balance Sheet Template

 

The red boxes highlight the important information we need to calculate ROTC, namely EBIT and the capital structure. Using the formula provided above, we arrive at the following figures:

 

Return on Total Capital Example - Ans

 

ROTC more than tripled from 2015 to 2017. This indicates the company is making good use of its capital structure and pursuing NPV-positive projects.

 

Additional Resources

Thank you for reading this CFI article on the Return on Total Capital ratio! CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following resources:

  • How to Calculate Debt Service Coverage Ratio
  • Current Portion of Long-Term Debt
  • Defensive Interval Ratio
  • ROAS (Return on Ad Spend)

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