Equity Ratio

What is Equity Ratio?

Equity ratio is the solvency ratio which helps in measuring the value of the assets which are financed using the owner’s equity. In simple words, it is a financial ratio that is used to measure the proportion of owner’s investment used to finance the assets of the company and it indicates the proportion of owner’s fund to total fund invested in the business and it is calculated by dividing the total equity of the company by its total assets.

Traditionally it is believed that the higher the proportion of the owner’s fund lower is the degree of risk. The investors will end up getting all the remaining assets left after paying off the liabilities.

Formula

The equity ratio is calculated as shareholders’ equity divided by total assets, and it is mathematically represented as,

Equity Ratio = Shareholder’s Equity / Total Asset

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For eg:
Source: Equity Ratio (wallstreetmojo.com)

Shareholders’ equity includes Equity share capitalEquity Share CapitalShare capital refers to the funds raised by an organization by issuing the company's initial public offerings, common shares or preference stocks to the public. It appears as the owner's or shareholders' equity on the corporate balance sheet's liability side.read more, retained earnings,Retained Earnings,Retained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more treasury stockTreasury StockTreasury Stock is a stock repurchased by the issuance Company from its current shareholders that remains non-retired. Moreover, it is not considered while calculating the Company’s Earnings Per Share or dividends. read more, etc. and Total assets are the sum of all the non-current and current assets of the company, and it should be equal to the sum of shareholders’ equity and the total liabilities.

Interpretation

  • Since this ratio calculates the proportion of owners’ investment in total assets of the company, therefore, a higher ratio is considered to be favorable for the companies.
  • A higher level of investment by the shareholders attracts more investment by the potential shareholders as they think that the company is safe for investing as already, the level of investment by the investor is higher.
  • Also, a higher investment level provides a level of security to the creditors as it shows that the company is not that risky to deal and they can lend funds thinking that the company will be able to easily pay off its debt.
  • Companies having a higher equity ratio also suggest that the company has less financing and debt service cost as a higher proportion of assets are owned by equity shareholders. There is no financing cost, including interest in financing through equity share capital as compared to the cost which is incurred in debt financing and borrowing through banks and other institutions.
  • It is suggested that if possible, companies should go for equity financingEquity FinancingEquity financing is the process of the sale of an ownership interest to various investors to raise funds for business objectives. The money raised from the market does not have to be repaid, unlike debt financing which has a definite repayment schedule.read more rather than debt financing because equity financing is always economical as compared to debt financing because there are various financing & debt service cost associated with debt financing. It is mandatory to pay off such debts whether the business is in a good state or not.

Example

Let’s take an example of a company named jewels ltd involved in the manufacturing of jewelry whose balance sheet reported the following assets and liabilities:

Total Assets = Current Assets + Non-Current AssetsNon-Current AssetsNon-current assets are long-term assets bought to use in the business, and their benefits are likely to accrue for many years. These Assets reveal information about the company's investing activities and can be tangible or intangible. Examples include property, plant, equipment, land & building, bonds and stocks, patents, trademark.read more

equity ratio 1

= $100,000

Shareholders’ Equity = $65,000

Therefore,

Equity Ratio = Shareholder’s Equity / Total Asset

equity ratio 1.23png

= 0.65

We can clearly see that the equity ratio of the company is 0.65. This ratio is considered to be a healthy ratio as the company has much more investor funding as compared to debt funding. The proportion of investors is 0.65% of the total assets of the company.

The Significance of Equity Ratio

Conclusion

Equity Ratio calculates the proportion of total assets financed by the shareholders as compared to the creditors. Generally, a higher ratio is preferred in the company as there is safety in terms of payment of debt and other liabilities because if more financing is done through equity, then there is no liability of paying interest, etc. and the dividend is not an obligation, it is paid if the company is earning profits, but a low ratio can also be seen as a good result for the shareholders if the interest rate paid to creditors is less than the return earned on assets. Therefore it is advised to the potential investors and creditors that equity ratio calculation should be analyzed from every angle before making any decision while dealing with the company.

This article has been a guide to what is Equity Ratio. Here we discuss Equity Ratio calculation using its formula (shareholder’s equity / Total assets) with examples and analysis. You may also have a look at the following financial analysis articles –

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