Chartered Financial Analyst (CFA) Level 1 Practice Exam

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What is the formula for Return on Total Capital?

EBIT / (Debt + Equity)
Net Income / Average Total Assets
Profit Margin / Sales
Operating Income / Total Debt

The correct answer is: EBIT / (Debt + Equity)

The formula for Return on Total Capital is indeed represented as EBIT (Earnings Before Interest and Taxes) divided by the sum of Debt and Equity. This measure, often referred to as the Return on Capital Employed (ROCE), indicates how well a company is utilizing its total capital to generate earnings before considering the costs of financing. Using EBIT in this formula allows for a focus on the operational performance of the business without the impact of capital structure decisions (i.e., how much debt or equity is used), giving a clearer picture of the operational efficiency and profitability generated from all available capital. In contrast, the other options focus on different aspects of financial performance. For example, net income divided by average total assets measures Return on Assets (ROA), which assesses profitability relative to total assets rather than total capital. Profit margin divided by sales looks at efficiency in generating profit from sales, and operating income divided by total debt assesses how effectively a company’s operating income covers its debt obligations, which is not the same as evaluating total capital efficiency.