What Is Equity Ratio?
The equity ratio is the solvency ratio that helps measure the value of the assets financed using the owner’s equity. It is calculated by dividing the company’s total equity by its total assets. It is a financial ratio used to measure the proportion of an owner’s investment used to finance the company’s assets.
It indicates the proportion of the owner’s fund to the total fund invested in the business. Traditionally it is believed that the higher the proportion of the owner’s fund the lower the degree of risk. The investors will get all the remaining assets left after paying off the liabilities.
Table of contents
- The equity ratio is the solvency ratio. It measures the asset’s value funded utilizing the owner’s equity.
- It is determined by dividing the total equity of the business by its assets. It is also a financial ratio that establishes how much of the owner’s investment funds the company’s acquisitions.
- It shows the owner’s fund proportion to the total fund spent in the business. It calculates the ratio of the total assets funded by the shareholders compared to the creditors. It also shows a company’s total financial capacity and verifies whether the capital structure is healthy.
Equity Ratio Explained
Equity Ratio calculates the proportion of total assets financed by the shareholders compared to the creditors. Generally, a higher ratio is preferred in the company as there is safety in paying debt and other liabilities. If more financing is done through equity, there is no liability for paying interest.
In this case of return on equity ratio, 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.
Thus, the metric is a very strong source of information regarding the extent to which the business relies on equity as a source of capital compared to debt funding.
In percentage terms, it quantifies the equity portion in the capital structure. Besides knowledge about the capital structure, it also helps assess the risk level and guide the management and stakeholders regarding investment decisions.
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
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., 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. 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. , etc., and Total assets are the sum of all the non-current and current assets of the company. It should be equal to the sum of shareholders’ equity and the total liabilities.
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Let us interpret the metric and understand why it is used in the financial market.
- Since this ratio calculates the proportion of owners’ investment in the company’s total assets, a higher good equity ratio is considered 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 security to the creditors as it shows that the company is not that risky to deal with. They can lend funds thinking that the company will be able to pay off its debt easily.
- Companies having a higher return on 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, compared to the cost incurred in debt financing and borrowing through banks and other institutions.
- 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. rather than debt financing because equity financing is always economical as compared to debt financing because there are various financing & debt service costs associated with debt financing. It is mandatory to pay off such debts whether the business is in a good state.
Let us understand the concept of good equity ratio with the help of some suitable examples.
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:
- Current Assets:Current Assets:Current assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc. $30,000
- Non-Current Assets: $70,000
- Shareholders’ Equity: $65,000
- Non-Current liabilities: $20,000
- Current Liabilities:Current Liabilities:Current Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc. $25,000
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.
Shareholders’ Equity = $65,000
Equity Ratio = Shareholder’s Equity / Total Asset
We can see that the equity ratio of the company is 0.65. This ratio is considered a healthy ratio as the company has much more investor funding than debt funding. The proportion of investors is 0.65% of the company’s total assets.
From the above example of equity ratio analysis, we see how the financial statement is used to identify the factors in the formula and calculate the ratio so as to arrive at a value that represents portion of equity in the total capital structure of the business.
The significance or importance of the equity ratio analysis in the financial market is highlighted in the points detailed below.
- Conservative companies are less risky as compared to leveraged companies. A company with an equity ratio greater than 50% is called a traditional company, whereas a company with less than 50% is called a leveraged firm. Since the equity ratio is 0.65, i.e., Greater than 50%.
- Conservative companies have to pay dividends only if there is profit. Still, in the case of leveraged companies, interest has to be paid no matter whether the company is earning profits. The creditors and the investors prefer to lend and invest in a high Equity Ratio company because it reflects that the company is managed conservatively and pays off the creditors timely.
- So, the companies with higher economic equity ratio face less risk. We can safely say in this case that the stakeholders can assess the risk level because more debt will signify higher leverage. If the ratio is low, the company is highly leveraged.
- Also, companies with a higher ratio are required to pay less financing costFinancing CostFinancing costs refer to interest payments and other expenses incurred by the company for the operations and working management. An enterprise often borrows money from different financing sources to run their operations in return for interest payments and capital gains., thereby having more cash for future growth & expansions; on the other hand, companies with lower ratios have to pay more cash to pay off their interest and debt.
- It also reflects a company’s overall financial strength. It is also used to check whether the capital structure is sound. A higher ratio shows a higher contribution from the shareholders. It indicates that the company has a better long-term solvencySolvencySolvency of a company means its ability to meet the long term financial commitments, continue its operation in the foreseeable future and achieve long term growth. It indicates that the entity will conduct its business with ease. position, and on the other hand, there is a high risk to creditors in case of a lower ratio.
- From the above point it can also be concluded that a good economic equity ratio increases the confidence level of investors since the company has less obligations to pay debts. The investors can be sure that the earnings remain with the company and are reinvested for better return.
Frequently Asked Questions ( FAQs)
Typically, a business aims to increase an equity ratio of about 0.5 or 50%. Hence, it shows that there is more altogether ownership rather than debt. In addition, it means that the company possesses more than its creditors.
Normally, the higher-value equity ratios show that a company constructively finances the asset needs with minimum debt. Moreover, this ratio increases for several reasons, including retained earnings, issuing new equity, debt reduction, and increased total assets
Average ratios can be regarded as “good” and “bad” and differ considerably from sector to sector. Moreover, a return on equity ratio is considered good if the return to equity ratio is 15% to 20%.
This article has been a guide to what is Equity Ratio. We explain the interpretation of the ratio along with significance & example. You may also have a look at the following financial analysis articles –