What it means
A company is funded from two very different pools, one short term and self-renewing, such as supplier credit and overdrafts, the other long term and committed. That second pool is made up of share capital, retained profit and term loans or bonds.
This ratio focuses only on it, because that is the funding on which owners and lenders expect a lasting return. The measure matters to anyone providing long-dated money.
A bank writing a seven-year loan and a shareholder holding a stake for a decade both want to know whether the permanent capital base earns enough to service its cost and still leave something over. If the return sits below the blended cost of that long-term funding, the structure is not sustainable however good the current year's profit looks.
The numerator is operating profit before interest and tax, which keeps the ratio neutral between debt and equity funding. The denominator, long-term funds, is calculated as shareholders' equity plus non-current liabilities, or equivalently as total assets minus current liabilities.
Because of that identity, the figure is often very close to return on capital employed, and in many textbooks the two are treated as the same measure. In practice the ratio appears most often in lending analysis and in businesses with long asset lives such as utilities, infrastructure and property.
It is also used in group reporting to test whether a subsidiary financed by long-term intercompany loans is earning its keep. Analysts usually track it over five years, since a single year can be distorted by a large capital project that has not yet started earning.
One nuance is worth flagging: the ratio is only fair if the long-term funds have had time to work. A company that raised a bond in November to build a plant opening two years later will show a depressed figure that reflects timing rather than poor performance, so unfinished projects are often excluded from the capital base.
In practice
Real-world examples.
Example
A toll road operator reports a return on long-term funds of 9% against a blended funding cost of 7%. The margin is thin but predictable, which suits the pension funds that hold its bonds and expect stability rather than growth.
Example
A family manufacturing group finds its ratio has fallen from 16% to 10% after taking a large term loan to buy a second site. The bank accepts the dip because the site is still being fitted out, but sets a covenant requiring recovery to 14% within three years.
Example
A conglomerate reviewing its divisions discovers one subsidiary earns 4% on the long-term funds tied up in it while another earns 19%. Rather than closing the weaker unit, the board recovers surplus long-term loans from it and redeploys the capital.
Think of it
“Return on long-term funds shows returns on your permanent capital-equity plus long-term debt.
Formula
Calculation
Return on Long-Term Funds = Operating Profit (EBIT) / (Shareholders' Equity + Long-Term Debt)
Take a regional waste treatment company. It reports operating profit of $3,300,000. Its balance sheet shows shareholders' equity of $17,000,000 and long-term borrowings of $5,000,000, plus $4,000,000 of current liabilities that are excluded from the calculation.
Long-term funds = $17,000,000 + $5,000,000 = $22,000,000.
Return on Long-Term Funds = $3,300,000 / $22,000,000 = 0.15, or 15%.
The company earns 15 cents of operating profit for every dollar of permanent capital. If the loan carries 7% interest and shareholders expect 12%, the blended cost of that $22,000,000 is roughly 10.9%, so the business is clearing its funding cost with a margin of about 4 percentage points.Case study
Seen in the real world.
What follows is an illustrative and fictional case. Thornmere Water Systems, an invented supplier of treatment equipment, had grown by borrowing long and buying plant, and its return on long-term funds had settled at 8%. The board was untroubled, because profits were rising in absolute terms every year.
A prospective lender ran the numbers differently. Thornmere's long-term funds had grown from $12,000,000 to $30,000,000 over five years while operating profit had gone from $1,800,000 to $2,400,000, so the return had fallen from 15% to 8%, below the roughly 9.5% blended cost of the company's capital. Every additional dollar of permanent funding was earning less than it cost.
The lender offered a smaller facility than requested and asked for a plan. In this fictional example, the company sold a half-used depot, repaid $6,000,000 of long-term debt, and lifted the ratio back to 10% within two years without any increase in profit at all.
Watch out
Common mistakes.
- Including overdrafts and trade payables in long-term funds. Short-term finance is not committed capital, and adding it understates the return on the money that genuinely is.
- Using profit after interest in the numerator. Interest is the reward paid to one of the funding providers being measured, so it must stay in the profit figure for the ratio to be neutral.
- Judging a single year in isolation. A newly raised loan or a plant still under construction depresses the ratio for reasons that have nothing to do with trading performance.
Questions
People also ask.
Is this the same as return on capital employed?
In most definitions the two are effectively identical, because total assets minus current liabilities equals equity plus non-current liabilities.
What should the ratio be compared against?
The blended cost of the company's own long-term funding, and then against directly comparable businesses with similar asset lives.
Does the ratio include deferred tax and provisions?
Practice varies, but since both sit among non-current liabilities they are usually included, and consistency across years matters more than the choice itself.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%