What it means
Total capital is everything the business has been funded with: short-term borrowings, long-term debt and shareholders' equity added together. The numerator is normally earnings before interest and tax, since interest is a payment to one of the capital providers rather than a cost of running the business.
Putting the two together gives a return that is not distorted by the mix of debt and equity. This is the ratio to reach for when comparing a heavily borrowed company with a debt-free one.
Return on equity would make the borrower look far better, while return on total capital treats both on the same footing. The most useful comparison is against the company's weighted average cost of capital, which is the blended rate it pays for all its funding.
If return on total capital sits comfortably above that rate the business is creating value, and if it sits below, growth is destroying it. That single comparison drives a great deal of corporate investment policy.
Definitions vary in one important way: some analysts use earnings before interest and tax, while others use the same figure after tax, which is closer to what investors actually receive. Both are defensible, but the after-tax version is the one to use when benchmarking against the cost of capital, because that rate is itself an after-tax measure.
The ratio is close enough to return on capital employed and return on invested capital that the three names get used loosely and interchangeably. The differences lie in whether items such as surplus cash, provisions and lease liabilities are included, so it is always worth asking exactly what a given source has counted.
In practice
Real-world examples.
Example
A board reviews a proposal to expand into a neighbouring country. The projected return on total capital is 7% against a cost of capital of 10%, so the plan is rejected despite adding revenue and profit in absolute terms.
Example
An investor compares two building products companies with identical returns on equity of 20%. Return on total capital is 14% for one and 8% for the other, revealing that the second company's headline figure rests almost entirely on borrowing.
Example
A private group uses return on total capital as the basis for its divisional bonus scheme. Managers who once competed for capital allocations now argue for releasing surplus assets, because a smaller capital base lifts the measure just as effectively as higher profit.
Think of it
“Return on total capital shows returns on all invested capital-debt and equity combined.
Formula
Calculation
Return on total capital = Earnings before interest and tax / (Short-term debt + Long-term debt + Shareholders' equity)
A commercial vehicle hire business reports earnings before interest and tax of $9,000,000. Its funding consists of $5,000,000 of short-term borrowings, $20,000,000 of long-term debt and $35,000,000 of shareholders' equity.
Total capital = $5,000,000 + $20,000,000 + $35,000,000 = $60,000,000.
Return on total capital = $9,000,000 / $60,000,000 = 0.15, or 15%.
On the after-tax version, with an effective tax rate of 25%, the numerator becomes $9,000,000 x (1 - 0.25) = $6,750,000, so the ratio is $6,750,000 / $60,000,000 = 0.1125, or 11.25%.
If the company's weighted average cost of capital is 9%, that after-tax return of 11.25% clears the hurdle with room to spare, and each additional dollar invested on similar terms adds value.Case study
Seen in the real world.
Kestrel Vale Logistics is a fictional haulage and warehousing group, described here purely as an illustrative example. It had grown by acquisition for six years, and revenue had tripled while the share price went nowhere.
The finance team calculated return on total capital for each acquired business. The original haulage operation earned $6,000,000 of earnings before interest and tax on $30,000,000 of capital, a return of 20%, while the warehousing businesses earned $4,000,000 on $80,000,000 of capital, a return of 5%. With a weighted average cost of capital of 9%, the warehousing arm had been consuming value from the day it was bought.
In this illustrative case the group sold two warehouse sites, repaid $35,000,000 of debt and refocused capital spending on haulage. Total profit fell in the first year, but return on total capital rose from 9.1% to 14%, and the share price followed the return rather than the revenue.
Watch out
Common mistakes.
- Using net income in the numerator, which deducts interest and so reintroduces exactly the financing effect the ratio exists to remove.
- Leaving short-term borrowings out of total capital, which understates the funding base and overstates the return.
- Judging the result against a general benchmark instead of against the company's own cost of capital, which is the only comparison that answers the value question.
Questions
People also ask.
How is this different from return on capital employed?
They are very close; return on capital employed is usually defined as total assets less current liabilities, which can differ from debt plus equity when there are large non-debt liabilities.
Should surplus cash be deducted from total capital?
Many analysts deduct it, on the basis that idle cash is not funding operations, but the treatment should be consistent across every company being compared.
Does a high return on total capital guarantee a good investment?
No, because the price paid for the shares still matters; a fine business bought at too high a price can still be a poor investment.
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