Equity Ratio
It is a measure of the amount of leverage that a company employs
Updated:
August 24, 2022The Equity ratio is a measure of the amount of leverage that a company employs. This ratio is achieved by comparing the total investment in assets to the total amount of equity. In such a situation, if the outcome of the calculation is high, it indicates that management has limited debt financing.
On the other hand, a low ratio implies that a higher proportion of debt was used to pay for assets in comparison to equity financing. In this case, we can say that management relies on leverage to maximize an organization's return on assets.
While leverage can result in a significant boost in ROI, it can also increase the likelihood of default if a business lacks the cash required to complete its scheduled debt payments.
The formula to calculate the following ratio can be given by dividing total equity by total assets. The formula is:
Equity ratio = Total Equity/ Total assets
In other words, all of the assets and equity reported on a firm's balance sheet are included in the above ratio calculation.
Interpreting the Equity Ratio
As many believe, a low ratio is not always a poor indicator of a company's financial position.
It implies that if the business is profitable, the return on investments is quite high since investors do not have to invest excessive funds compared to the return generated.
In contrast, if the company's results turn out to be unprofitable, any interest expense associated with the debt could quickly eliminate all cash reserves and propel the business into bankruptcy.
Moreover, a low ratio is more manageable for a business to sustain in an industry where sales and profits have low volatility over time.
On the other hand, a competitive industry experiencing high market volatility may be unfavorable for a company to have a low ratio since it is difficult to pay back debt obligations in such an environment.
It is also essential to point out that a higher ratio is generally a preferred option for potential investors and creditors as it signals that a company is conservatively managed, always paying its bills on time, and is shielded from any insolvency risks.
A firm with a low ratio is also less likely to receive money from lenders since, from their perspective, the incremental risk of doing so is too high unless they are guaranteed collateral to lower their risk.
Equity financing is less expensive as compared to debt financing. Therefore, businesses with higher equity ratios are expected to have more affordable debt payments and financing expenses than those with lower ratios.
What are the ways a company can improve its ratio?
1. Increase the value of a company's assets by achieving higher sales and net profit. To achieve this goal, prices of goods and services should be raised, and the cost of production must be reduced.
2. A second option could be to sell more shares to investors, whereby the resulting funds can be used effectively to pay down any debt obligations.
3. A company could also aim to collect accounts receivable faster since it will make more cash available to pay for outstanding debts. The latter can be made possible by tightening credit terms and implementing more aggressive collection activities.
4. Another option could be to negotiate longer payment terms with suppliers.
5. Restructuring debt also provides an alternative way to improve the latter by reducing the debt-to-capital ratio. For example, if a business is experiencing high-interest rates on its loans and current interest rates are lower, the latter can look for ways to refinance its existing debt. This practice will lower interest expenses, improving the company's profitability, cash flow, and capital stores.
A Practical example of calculating the ratio
ANZ Motors- Balance Sheet- 2022
| Assets | ||
| Non-Current Assets | ||
| Plant and Equipment | $ | 55,000 |
| Vehicle | $ | 75,000 |
| investments | $ | 170,000 |
| Current Assets | ||
| Cash and cash equivalent | $ | 15,000 |
| Accounts receivable | $ | 22,000 |
| Inventory | $ | 115,000 |
| Prepaid expenses | $ | 20,000 |
| Total Assets | $ | 472,000 |
| Current Liabilities | ||
| Accounts payable | $ | 30000 |
| Short term loan | $ | 75000 |
| Accrued expenses | $ | 15,000 |
| Unearned Revenue | $ | 18,000 |
| Total Current Liabilities | $ | 138,000 |
| Non-Current Liabilities | ||
| Loan term loan | $ | 200,000 |
| Total Liabilities | $ | 338,000 |
| Equities | ||
| Share capital | $ | 90,000 |
| Retained earnings | $ | 40,000 |
| Net income & dividends | $ | 4,000 |
| Total Equity | $ | 134,000 |
| Total Equity and Liabilities | $ | 472,000 |
From the above snapshot of the balance sheet, we can calculate ANZ Motors Equity Ratio as follows:
Total Equity= ( 90,000+ 40,000+4,000) = $134,000
Total Asset = ( 55,000+75000+ 170,000+15000+ 22000+ 115,000 + 20000) = $472,000
Equity Ratio =( 134,000/ 472,000) = 28.389 %
We can conclude that ANZ motors' equity ratio is 28.389 %, implying that its equities are financing only 28.389% of the assets acquired.
It also implies that the company is highly leveraged- a high proportion of debt financing compared to equity financing. Consequently, it is a negative indicator for investors as it translates into a company that depends too much on borrowing. For investors and creditors, investing is a risky move.
Hence, ANZ motors might reduce its long-term debts by relying more on equities.
Nevertheless, we can also say that the ratio is not a perfect tool to measure a company's financial health.
There are certain aspects that the ratio cannot capture; for instance, the latter can be manipulated by the accounting of accrual-based revenue that increases retained earnings.
Conclusion
- The latter indicates how much equity a company uses to fund its assets. It can also be referred to as the shareholder's equity ratio.
- The formula for the latter requires two variables: total equity and total assets.
- The results of the above-mentioned ratio are usually expressed as a percentage.
- Businesses with a lower than 50% ratio are considered leveraged, while those with more than 50% are called conservative companies.
- The higher the ratio is, the easier it will be for shareholders and creditors to take possession of the company's assets in the event it's liquidated.
FAQs
In the above calculation, we determine the percentage of a company's assets funded solely by equity. The ratio realizes this by measuring the proportion of equity inside the company's total assets and the resources a company uses for its day-to-day operations.
A company would find it suitable to have a high enough ratio to show that it is not highly leveraged but at the same time low enough so as not to hamper its growth. According to various sources, a healthy ratio revolves around 50%.
The above statement indicates that the company is using a good amount of its equity to finance its business but still possesses growth potential.
A high ratio is a positive sign as it indicates the company is relying less on debt financing, making the company a safer bet in times of financial crisis and in a better position to pay off its debts quickly. It also shows that the business is effectively managing its assets.
The calculation divides a firm's total equity by its assets. The latter consists of the money/ cash that shareholders have invested into the business, while assets are everything a company owns and uses for generating revenue.
Everything You Need To Break into Private Equity
Sign Up to The Insider's Guide on How to Land the Most Prestigious Buyside Roles on Wall Street.
Researched and Authored by Alvin Dookhony | LinkedIn
Reviewed and edited by Colt DiGiovanni | LinkedIn
Free Resources
To continue learning and advancing your career, check out these additional helpful WSO resources:
or Want to Sign up with your social account?