Return on Total Capital

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 structureCapital StructureCapital Structure refers to the amount of debt and/or equity employed by a firm to fund its operations and finance its assets.  The structure is typically expressed as a debt-to-equity or debt-to-capital ratio. Debt and equity capital are used to fund a business’ operations, capital expenditures, acquisitions,. This ratio is different from return on common equityReturn on Common EquityThe Return on Common Equity (ROCE) refers to the return that common equity investors receive on their investment. This ratio is different from Return on E.. (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 would have a high ROCE, which can be a misleading metric to look at.

ROTC gives a fairer assessment of the company’s use of funds to finance its projects and functions better as an overall profitability metric. Thus, the ratio is immune from artificial inflationInflationInflation is an economic concept that refers to increases in the price level of goods over a set period of time. The cause for inflation in the short and me induced by a capital structure that employs a significantly higher amount of debt capital than equity capital, or a significantly lower amount of debt capital than equity capital.

Return on Total Capital can be used to evaluate how well the company’s management has utilized its capital structure to generate value for both equity and debt holders. Thus, it can be said that 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:

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 that a business had no liabilities outside of its short-term debt, long-term debt and total equity, return on total capital would be virtually identical to the return on assets (ROA) ratioReturn on Assets & ROA FormulaReturn on assets (ROA), a form of return on investment, measures the profitability of a business in relation to its total assets. The ROA formula is used to indicate how well a company is performing by comparing the profit it's generating to the capital it's invested in assets.  The higher the return, the more. It is because the business’ capital structure would make up the entirety of the business’ liability section on its balance sheet, which 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 the business’ use of capital. It is because ROA measures the value a business is able to generate based on the assets that it employs, rather than 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:

The red boxes highlight the important information that we will need to calculate ROTC, namely EBITEBIT GuideEBIT stands for Earnings Before Interest and Taxes and is one of the last subtotals in the income statement before net income.  EBIT is also sometimes referred to as operating income and is called this because it's found by deducting all operating expenses (production and non-production costs) from sales revenue. and the capital structure. Using the formula provided above, we arrive at the following figures:

In such as case, we see that ROTC more than tripled from 2015 to 2017, which may be an indication that the company is making good use of its capital structure, and is pursuing NPV-positive projects.

Additional Resources

Thank you for reading this article! CFI offers the Financial Modeling & Valuation Analyst (FMVA)™FMVA™ CertificationThe Financial Modeling & Valueation Analyst (FMVA)™ accreditation is a global standard for financial analysts that covers finance, accounting, financial modeling, valuation, budgeting, forecasting, presentations, and strategy. certification program for those looking to take their careers to the next level. To learn more about related topics, check out the following resources:

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