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 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
Equity ratio is calculated as shareholders’ equity divided by total assets and it is mathematically represented as,
Shareholders’ equity includes Equity share capital, retained earnings, treasury stock, 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 favourable 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 higher equity ratio also suggest that the company is having less financing and debt service cost as the higher proportion of assets are owned by equity shareholders and 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 the equity financing 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 and 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:
- Current Assets: $30,000
- Non-Current Assets: $70,000
- Shareholders’ Equity: $65,000
- Non-Current liabilities: $20,000
- Current Liabilities: $25,000
Total Assets = Current Assets + Non-Current Assets
= $100,000
Shareholders’ Equity = $65,000
Therefore,
Equity Ratio = Shareholder’s Equity / Total Asset
= 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
- The company had an equity ratio greater than 50% is called a conservative company whereas a company has this ratio of less than 50% is called a leveraged firm. In the given example of jewels ltd, since the equity ratio is 0.65 i.e. Greater than 50%, the company is a conservative company. Conservative companies are less risky as compared to leveraged companies.
- Conservative companies have to pay dividends only if there is profit but in the case of leveraged companies interest has to be paid no matter the company is earning profits or not. So, the companies with higher equity ratios face less risk and the creditors and the investors prefer to lend and invest in high Equity Ratio company because it reflects that the company is managed conservatively and pay off the creditors timely.
- Also, the companies which are having higher ratio are required to pay less financing cost thereby having more cash for future growth &expansions; on the other hand companies with lower ratios have to pay more cash to pay off its interest and debt
- It also reflects a company’s overall financial strength. It is also used to check whether the capital structure is sound or not. A higher ratio shows a higher contribution of the shareholders and indicates that the company is having better long-term solvency position and on the other hand there is a high risk to creditors in case of a lower 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 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 taking any decision while dealing with the company.
Recommended Articles
This 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 –
