The equity ratio formula shows the relationship between the total equity to total assets of a firm. The financial metric gives an insight into the financial strength of a company. It gives the percentage of assets that are financed by equity which in turn helps to determine the amount of financial leverage that a company uses. We will see how to apply this formula in the equity ratio calculation, its importance, and its interpretation.
What is equity ratio?
The equity ratio is a financial metric that measures how much of a company’s assets have been generated by issuing equity shares rather than by taking on debt. It also measures the amount of leverage that a company makes use of. The equity ratio is a solvency ratio that makes use of investments in assets and the amount of equity to determine how well a company manages its debts as well as how it funds its asset requirement. The equity ratio is also known as the proprietary ratio.
The lower the result of the ratio, the more debt a company has used to pay for its assets. In other words, a lower equity ratio implies that the company primarily used debt to acquire its assets and it is widely viewed as an indication of greater financial risk.
Ratios with a higher value generally are indicators that the company effectively funded its asset requirements with a minimal amount of debt. The proprietary ratio also shows how much shareholders might receive in a case whereby the company is forced into liquidation. It is expressed as a percentage.
In a case whereby a company is relying on leverage to boost its returns on investment, the risk of default increases if a business does not have enough cash to make scheduled debt payments.
If a company sells all of its assets for cash to pay for all of its liabilities, any cash remaining is equal to the firm’s equity. A company’s shareholders’ equity is the sum of the value of its common stock, additional paid-in capital, and retained earnings. The sum of these components is considered the true value of a business.
When the equity ratio of a company approaches 100%, it is an indication that the company has financed almost all of its assets with equity instead of taking on debt to do so. However, equity capital has some drawbacks compared to debt financing. It tends to be more expensive than debt and requires some ownership dilution as well as giving voting rights to new shareholders.
It is easier for a business to sustain a low equity ratio in an industry where sales and profits have minimal volatility over time. On the other hand, highly competitive industry with market shares that are constantly changing may be a bad place to have a low equity ratio. It can be quite difficult to pay back debt in such an environment.
Creditors and potential investors prefer to see a high equity ratio because it indicates that the company is conservatively managed, always pays its bills on time, and has no likelihood of becoming insolvent. Lenders are unlikely to lend additional funds to a company with a low equity ratio. This is because the incremental risk of doing so is too high unless the collateral is being obtained to reduce their risk.
The proprietary ratio is said to be most meaningful in making a comparison with the company’s peers or competitors in the same sector/industry. The standard or normal level of equity to assets varies across industries.
Equity ratio formula
The equity ratio is expressed as a percentage and it is calculated by dividing the total shareholders’ equity by the company’s total assets. The equity ratio formula is expressed in the image below; The result represents the value of assets on which shareholders have a residual claim.
Equity ratio calculation
In order to carry out the equity ratio calculation, one has to first obtain the figures from the balance sheet of a company. In other words, the figures needed in order to calculate the equity ratio are recorded on the balance sheet. After obtaining these figures, simply place them at the right spot on the equity ratio formula.
Let us consider a hypothetical company, Joanna Inc. An investor is considering investing in this company and is interested in knowing its financial strength and overall debt situation. We are to calculate its equity ratio.
From the company’s balance sheet, the total assets value of the company is $3.5 million, total liabilities of $750,000, and the shareholder’s equity value is $2.26 million. The equity ratio will be calculated using the equity ratio formula;
Equity ratio = Total equity / Total assets
Equity ratio = $2,260,000 / 3,500,000
Equity ratio = 0.65 or 65%
The result tells us that Joanna Inc has financed 65% of its assets with shareholders’ equity, meaning that only 35% of its assets are funded by debt. In other words, if Joanna Inc liquidated all of its assets to pay off its debt, the shareholders would retain 65% of the company’s financial resources.
Equity ratio interpretation
Because the proprietary ratio calculates the proportion of owners’ investment in the total assets of the company, a higher ratio is considered to be favorable for companies.
A higher level of shareholder investment attracts more investment by potential investors or shareholders. This is because they think that the company is a safe place for investing as the level of investment by investors is higher.
Another thing is that a higher level of investment provides security to the creditors because it shows that the company is not risky to deal with. With this, they can lend funds with the thought that the company will be able to pay off its debts easily.
As earlier stated, companies with a higher equity ratio suggest that the company financed their assets with less debt, and a higher proportion of assets are owned by equity shareholders. There is no cost of financing through equity share capital compared to the cost incurred in debt financing and borrowing through banks and other financial institutions.
A lower equity ratio implies that the company used more debt financing than equity financing to pay for its assets. It is not in all cases that a low equity ratio is bad. It can mean that if the business is profitable, the return on investment is quite high since investors do not have to invest an extreme amount of funds in comparison to the return generated.
However, if the results of company become unprofitable, the interest expense that has to do with the debt can quickly eliminate all cash reserves and push the company into bankruptcy. This is not necessarily the case when interest rates are low since little cash flow is required to pay for ongoing interest costs.
If possible, it has been suggested that companies should go for equity financing rather than debt financing because equity financing is always economical compared to debt financing. This is because there are different financing and debt service costs such as interest rates associated with debt financing. It is mandatory for a business to pay off all its debts whether it is in a good state or not.
Importance of equity ratio
Conservative companies are less risky than leveraged companies. A company with an equity ratio that is greater than 50% is referred to as a conservative company. On the other hand, a company that has an equity ratio of less than 50% is called a leveraged company. In the example of Joanna Inc given above, we can say that this company is conservative because its equity ratio is 65% which is greater than 50%.
The point here is that investors tend to look for companies that are in the conservative range because of their less risky nature. Such companies know how to gather and fund asset requirements without having to incur substantial debt. Lenders on the other hand are more likely to extend their credits to such companies with a higher ratio. A higher ratio is an indication that the company is managing money effectively and the business will be able to pay off its debts in a timely way.
Conservative companies pay dividends only in cases where there is profit. In the case of leveraged companies, interest must be paid regardless of whether the company is earning profits or not. With this, investors and lenders prefer a company with a high equity ratio.
Having said all this, the equity ratio is important in the sense that it reflects the overall financial strength of a company. It is used to check whether a company’s capital structure is sound. With this, a higher ratio value shows that the company is financially strong all around and enjoys a greater long-term position of solvency than companies with lower ratios.
How is equity ratio calculated?
The equity ratio is calculated by dividing the total shareholders’ equity by the company’s total assets. It is represented in a formula as;
Equity ratio = Total equity / Total assets
Is a higher equity ratio better?
Since an equity ratio shows a company’s financial strength and solvency, a higher equity ratio is better for a company. A lower equity ratio implies that the company used more debt financing to pay for its assets which indicates financial risk. Therefore, investors and lenders prefer to invest and lend to companies with a higher equity ratio. While investors think that these companies are safe to invest in, lenders consider it safer to lend to these companies.