The equity ratio investors use to analyze how much a company leverages to invest in assets. Mainly, the equity ratio shows the amount of share capital being financed in the assets of the company.
Higher the equity ratio considered lowers the risk of the company and would be a better investment option for the investors.
What is an Equity Ratio?
The equity ratio is a solvency ratio that measures how much amount of assets are being financed by the owner's capital. It represents the relationship between the total equity and total assets of the company.
In simple words, the equity ratio represents the proportion of equity's capital used to finance the assets of the company. This ratio is the inverse of the debt to asset ratio.
The equity ratio measures the solvency or long term position of the company. The components of the equity ratio would be reported on the balance sheet of the company.
What is the Equity Ratio Formula?
The equity ratio can be calculated by dividing total equity by the total assets of the company. The equity ratio formula is as follows:
Where,
Total Equity:
The total equity shows how much percentage of a company is owned by equity investors. It includes share capital, reserves and surpluses.
Total Assets:
The total assets indicate the current assets and fixed assets of the company. Total assets can be financed either by debt or equity. Hence, investors also evaluate how much assets are financed by debt funds.
Equity Ratio Example
It is an ABC company. Here is some information about the ABC company.
The balance sheet of ABC company as on 31.03.2019
Particular | Amount |
---|---|
Non-current assets | |
Fixed assets | 425,000 |
Long term investments | 390,000 |
Total non-current assets | 815,000 |
Current assets | |
Cash in hand | 20,000 |
Bills receivable | 50,000 |
Inventory | 250,000 |
Prepaid expenses | 100,000 |
Short term loans | 200,000 |
Total current assets | 620,000 |
Total assets | 14,35,000 |
Equity | |
Share capital | 600,000 |
Reserve | 330,000 |
Total equity | 930,000 |
Non-current liabilities | |
Debentures | 200,000 |
Long-term loans | 150,000 |
Total non-current liabilities | 350,000 |
Current liabilities | |
Bills payable | 50,000 |
Overdraft | 100,000 |
Short-term loans | 5,000 |
Total current liabilities | 155,000 |
Total equity and liabilities | 14,35,000 |
Equity ratio = (9,30,000 / 14,35,000)
Equity ratio = 0.64 or 64%
The equity ratio of 64% means, 64% of the total assets of the company are financed by equity capital.
How do you interpret the Equity Ratio?
The equity ratio is a leverage ratio that gauges the portion of assets of the company financed by equity capital. This ratio measures the financial ability of the company.
A company with a higher equity ratio indicates that a company uses more equity capital for purchasing assets compared to a debt fund. Hence, the higher portion of assets is held by the equity holders. The company may have room in its financial facility to determine more obligations.
A low equity ratio indicates that more use debt funds for purchasing total assets. It also shows a huge portion of debt in the total assets may minimize the creditor's interest and increase the finance costs. Hence, the company has a chance to become bankrupt. A lower equity ratio is unfavourable to the investors.
Equity financing is cheaper than debt financing because of interest expenses and it is compulsory to pay back obligations. Investors and analysts always prefer a higher equity ratio than a lower ratio.
What is a good Equity Ratio?
Generally, a good equity ratio of a company should be 0.50 or 50%, which refers to the more equity shareholders in the company compared to debt. We can also say, the major proportion of assets owned by the company than creditors.
A company with an equity ratio above 50% is considered a conservative company and below 50% is considered a leveraged company.
A conservative company is considered less risky than leveraged. A leveraged company has to be paid interest on debt while a conservative company would distribute dividends to the shareholders.
Some industries are more capital intensive than others. Hence, a good equity ratio will be varying from one industry standard and benchmark to another. It is better to find out the trend of equity ratio in the last few years.
Conclusion of Equity Ratio
- The equity ratio measures that how much amount of assets are being funded by equity capital.
- The two major factors of equity ratio - Total equity and Total assets.
- The companies with have more than 50% equity ratio is considered conservative and less than 50% of the equity ratio is considered leveraged.
- Generally, investors often prefer the higher equity ratio of the company.
FAQs
- What is the total equity formula?
The total equity is the amount of the company after deducting total liabilities from total assets. The total equity formula is following:
Total equity = Total Assets - Total Liabilities
- What is the equity to asset ratio?
The equity to asset ratio is a financial ratio that indicates how much amount of assets are being purchased by the equity capital.
- Is a higher equity ratio better?
A higher equity ratio indicates that a company has purchased more assets by equity capital than debt. A higher equity ratio means a company is in a good long term solvency position. Therefore, a higher equity ratio is better for a company.
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