What is Return on Total Capital?
Return on total capital is a profitability ratio. It is a measure of the return an investment generates for those who contribute capital, i.e. bondholders and stockholders. Return on total capital signifies how effective a company is at turning capital into profits.
How Does Return on Total Capital Work?
Looking at an example, Manufacturing Company MM has $100,000 in net income, $500,000 in total debt and $100,000 in shareholder equity. Its operations are straightforward -- MM makes and sells widgets.
We can calculate MM's return on total capital with the given equation: (Net income - Dividends) / (Debt + Equity) = (100,000 - 0) / (500,000 + 100,000) = 16.7%
note that for some companies, net income may not be the most useful profitability measure to use. You want to make sure that the profit metric you put in the numerator provides a genuine measure of profitability.
Return on total capital is most useful when you're trying to determine the returns generated by the business operation itself, not the short-lived results from one-time events. Gains/losses from foreign currency fluctuations and other one-time events are included in the net income listed on the bottom line, but they do not result from business operations. Try to think of what your business "does" and only consider income related to fundamental business operations.
As an example, let's say, Conglomerate CC shows $100,000 as net income, $500,000 in total debt and $100,000 in shareholder equity. But when you look at CC's income statement, you see a lot of extra line-items, like "gains from foreign currency transactions" and "gains from one-time transactions."
In the case of CC, if you use the net income number, you are not using a specific measure as to where the returns are being generated. Were they from strong business results? Were they from fluctuations in the foreign currency markets? Did CC sell a subsidiary?
For CC, it is better to use an income measure called net operating profits after tax (NOPAT) as the numerator. It's not found on the income statement, but you can calculate it yourself using the following equation:
Using NOPAT in the equation will tell you the return for both its bondholders and stockholders the company generated with its operations.
Why Does Return on Total Capital Matter?
A firm's return on total capital can be an outstanding indicator of the size and strength of its moat. If a company is able to generate returns of 15-20% year after year, it has a great system for converting investor capital into profits.
Return on total capital is especially useful for companies that invest lots of capital, like oil and gas firms, computer hardware companies, and even big box stores. As an investor, it's imperative to know that if a company uses your money, you'll get a respectable return on your investment.