Chartered Financial Analyst (CFA) Level 1 Practice Exam

What does the Return on Capital formula calculate?

1. FFO / Total debt

2. EBIT / Average Total Capital

3. CFO - preferred dividends

4. Common share dividends / Net income attributable to common shares

The correct answer is: EBIT / Average Total Capital

The Return on Capital formula measures the efficiency and profitability of a company's capital utilization. It specifically calculates how well a company can generate earnings from its capital investments by comparing earnings before interest and taxes (EBIT) to the average total capital employed in the business. By using EBIT in the numerator, the formula focuses on the operational performance of the business without the effects of capital structure (debt versus equity) and taxation. The denominator, average total capital, includes both equity and debt, providing a comprehensive view of the total capital invested in the company. This metric is significant for investors and analysts, as it indicates how effectively a company is using its capital to generate profits. A higher return on capital suggests better performance and efficiency in utilizing funds, making the company more attractive to potential investors. Thus, this choice accurately represents the purpose of the Return on Capital formula. The other options pertain to different financial metrics and do not capture the concept of return on capital. For instance, funds from operations (FFO) relate to cash generation in real estate, cash flow from operations (CFO) looks at operational cash flows, and the dividend-to-net income ratio focuses on shareholder returns, none of which are aligned with the concept of capital efficiency as presented in