Return on total capital definition
/What is the Return on Total Capital?
The return on total capital measures the efficiency with which invested funds are used in a business. It compares the profitability of an organization to the aggregate amount of funds invested in it. The concept is most applicable to firms that use large amounts of debt in their capital structure. These entities employ leverage to achieve a high return on equity. To see how they are performing when using all forms of funding, we use the return on total capital.
How to Calculate Return on Total Capital
The formula for the return on total capital is to divide earnings before interest and taxes by the aggregate amount of debt and equity. Earnings before interest and taxes appears on an organization’s income statement, while the debt and equity items appear on its balance sheet. The calculation is:
Earnings Before Interest and Taxes ÷ (Debt + Equity)
= Return on total capital
The measurement can be altered to use operating profit, if there are stray profitability results from financing and other activities that are materially skewing the results. For example, there may be a large amount of derivative-based income that masks an operating loss.
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The Interpretation of Financial Statements
Example of the Return on Total Capital
A business has generated $150,000 of earnings before interest and taxes. As of the end of the reporting period, it has $300,000 of debt and $700,000 of equity. Its return on total capital is:
$150,000 Earnings Before Interest and Taxes ÷ ($300,000 Debt + $700,000 Equity)
= 15% Return on total capital
Advantages of Using the Return on Total Capital
There are several advantages to using the return on total capital metric. One is that it provides a balanced view of performance by considering the entire capital structure, making it especially useful when comparing companies with different financing strategies. Unlike the return on equity, which only reflects shareholder returns, ROTC accounts for the obligations to lenders, offering a clearer picture of operational efficiency. It also helps investors and managers assess whether the company's returns justify the cost of capital employed. Additionally, ROTC is useful in evaluating investment opportunities and long-term financial sustainability by highlighting how well a company turns total capital into earnings before interest and taxes.