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What is the Return on Total Capital?

Return on Total Capital

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Return on Total Capital

The Return on Total Capital (ROTC) is a profitability ratio that measures the return that a company generates on its total capital invested. This includes both equity and debt capital. It’s a useful metric to assess how effectively a company is using its capital to generate profits.

The formula for Return on Total Capital is:

ROTC = EBIT / TotalCapital

Where:

  • EBIT stands for Earnings Before Interest and Taxes. This is used because it allows for a clearer comparison of how a company uses its capital, regardless of its financial structure (debt vs. equity) and tax strategy.
  • TotalCapital typically includes long-term debt and total shareholders’ equity. It represents the total capital invested in the business.

This ratio is especially useful when comparing companies in capital-intensive industries or when trying to evaluate companies with varying levels of debt. A higher ROTC typically indicates that a company is effectively using its capital to generate returns.

Example of the Return on Total Capital

Let’s consider a hypothetical example to illustrate the calculation of Return on Total Capital (ROTC):

ABC Manufacturing Company’s Financial Data (in USD):

  • Earnings Before Interest and Taxes (EBIT): $1,000,000
  • Long-term Debt: $4,000,000
  • Shareholders’ Equity: $6,000,000

From the given data:

Total Capital = Long-term Debt + Shareholders’ Equity

Total Capital = $4,000,000 + $6,000,000
Total Capital = $10,000,000

Now, plug these values into the ROTC formula:

ROTC = EBIT / TotalCapital

ROTC = $1,000,000 / $10,000,000

ROTC = 0.1 or 10%

In this example, ABC Manufacturing Company has a Return on Total Capital of 10%. This means that for every dollar of total capital invested in the business (including both debt and equity), the company generates a return of $0.10 before paying interest and taxes.

It’s important to then compare this ROTC value with industry peers or the company’s historical values to determine if it’s good, average, or below par.

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