Meaning and Definition of Equity Ratio
The equity ratio is a financial formula which indicates the proportion of owner capital, such as direct owner investments or shareholders, used to fund a company’s assets. The equity ratio excludes any debt financing used by a company to raise funds.
The equity ratio is a financial ratio indicating the relative proportion of equity used to finance a company’s assets. The two components are often taken from the firm’s balance sheet or statement of financial position (so-called book value), but the ratio may also be calculated using market values for both, if the company’s equities are publicly traded.
The equity ratio is a variant of the debt-to-equity-ratio and is also, sometimes, referred as net worth to total assets ratio. The equity ratio communicates the shareholder’s funds to total assets in addition to indicating the long-term or prospective solvency position of the business.
The equity ratio is a very common financial ratio, especially in Central Europe and Japan, while in the US the debt to equity ratio is more often used in financial (research) reports.
The equity ratio is a good indicator of the level of leverage used by a company. The equity ratio measures the proportion of the total assets that are financed by stockholders, as opposed to creditors. A low equity ratio will produce good results for stockholders as long as the company earns a rate of return on assets that is greater than the interest rate paid to creditors.
Calculating of Equity Ratio
The equity or proprietary ratio is calculated by dividing the shareholders’ funds by the total assets. The formula for creation of a balance sheet is assets less liabilities equals equity. For example, if a company sold all of its assets for cash and used the cash to pay off all liabilities, any remaining cash equals the firm’s equity. A company’s shareholders’ equity is the sum of common stock, additional paid in capital and retained earnings. The sum of these parts is considered to be the true value of a business.
Formula for equity ratio
The formula used to calculate equity ratio is:
Equity Ratio = Total equity / Total assets
Company ABC’s balance sheet indicates total stockholder equity of $30,000,000 and total assets of $50,000,000. The equity ratio for Company ABC would be:
Equity Ratio = $30,000,000 / $50,000,000 = 0.6
This implies that of every $1 employed in the business, the contribution of shareholders is about 60 cents. The creditors’ contribution, therefore, would be 40 cents.
Significance of Equity ratio
The equity ratio throws light on a company’s overall financial strength. Besides, it is also treated as a test of the soundness of the capital structure. A higher equity ratio or a higher contribution of shareholders to the capital indicates a company’s better long-term solvency position. A low equity ratio, on the contrary, includes higher risk to the creditors.
The equity ratio highlights two important financial concepts of a solvent and sustainable business. The first component shows how much of the total company assets are owned outright by the investors. In other words, after all of the liabilities are paid off, the investors will end up with the remaining assets.
The second component inversely shows how leveraged the company is with debt. The equity ratio measures how much of a firm’s assets were financed by investors. In other words, this is the investors’ stake in the company. This is what they are on the hook for. The inverse of this calculation shows the amount of assets that were financed by debt. Companies with higher equity ratios show new investors and creditors that investors believe in the company and are willing to finance it with their investments.
A low equity ratio is not necessarily bad. It means that, if the business is profitable, the return on investment is quite high, since investors did not have to invest an inordinate amount of funds in comparison to the return generated. However, if the company’s results become unprofitable, the interest expense associated with the debt could quickly eliminate all cash reserves and thrust the company into bankruptcy. This scenario is not necessarily the case when interest rates are low, since it requires little cash flow to pay for ongoing interest costs.
A low equity ratio is easier for a business to sustain in an industry where sales and profits have minimal volatility over time. Conversely, a highly competitive industry with constantly changing market shares may be a bad place in which to have a low equity ratio.
Potential investors and creditors prefer to see a high equity ratio, since it implies that a company is conservatively managed and always pays its bills on time.
Importance of a reasonable equity ratio
The reasons and importance of having a reasonable equity ratio for a company is explained as follows. Companies having a higher equity ratio have to pay less interest thus having more free cash on hand for future expansions, growth, and dividends. On the contrary, a company with a lower equity ratio is more prone to losses for a large portion of its earnings is spent in paying interests. Besides a higher equity ratio provides a freer access to capital at lower interest rates. A lower equity ratio, on the other hand, makes it difficult for a company to obtain loan from banks and other financial institutions. If, in ay case, they manage to get a loan, it is at comparatively higher interest rates.