What is Equity Ratio and How Does It Relate to Debt & Shareholders?

Determining the value or stability of a company can be tricky unless you know the right formulas. Fortunately, you can find a company’s equity ratio using a relatively simple formula and quickly determine key things like:

• How much of the company is owned by investors vs owned by lenders
• The management style of a company in general
• ...and more!

Don’t know how to calculate equity ratio or fully understand how it works? No problem. This guide will break down equity ratio in detail and show some examples. Let’s get started.

What is Equity Ratio?

The equity ratio is a measurement that tells you how much leverage a business or company can employ. Leverage , in this sense, is the amount of borrowing power a company has. By using leverage, a company can borrow money to expand and increase its potential return on investment. The more leverage the company has, the more it can do overall. Put in a simpler way, leverage is how much debt a firm or company can use to finance its assets. More specifically, the equity ratio directly measures the number of assets financed by company investments. It does this by comparing total company equity to total assets. If the equity ratio shows a high value, it means that a company has minimized debt usage to fund any of its asset requirements (i.e. infrastructure, employees, expansion, etc.). This necessarily means that the company uses actual cash or profits to make those necessary purchases. It shows a conservative company direction. In contrast, a low equity ratio indicates that lots of debt or leverage were used to pay for existing assets. This may indicate a risky or debt-heavy strategy. Both outcomes can tell investors, company owners, and analysts about a company and its management.

What is Equity Ratio Used For?

The equity ratio is calculated in order to show two things. Firstly, it shows how much of a company’s assets are actually owned by its investors (which can sometimes be company executives depending on how large the company is). Analysts and accountants will often calculate this to determine which assets, if any, investors may end up with if liabilities are paid off and the company is liquidated. The second main thing the equity ratio shows is company leverage. It can show investors and analysts how much stake investors have in a company and how much of the company’s assets are connected to debt. Now let’s examine what these actually mean in business contexts. For example, a low equity ratio isn’t always a bad thing. If a given business is still profitable and its return on investment is high, investors may not have had to invest tons of funds in order to make a profit. This being said, a low equity ratio with an unprofitable company could show that management is doing a bad job and that the company may be in danger of bankruptcy. Furthermore, low equity ratios are typically easier for businesses to sustain if they are in an industry where their sales and profits have minimal volatility (i.e. it's a really stable business, and profits and sales are expected to remain consistent year after year). Of course, this means that companies in very competitive or volatile industries don't want to see a low equity ratio. Generally speaking, creditors, potential investors, and accountants like to see high equity ratios overall. This implies a conservative company management style, which itself implies other things like:

• Management doesn’t take a lot of unnecessary outstanding debt
• Bills are paid on time
• The company is not likely to become insolvent
• The company’s assets can be liquidated in the event of bankruptcy or economic emergency

So, simply put, a low equity ratio is not always a bad thing. But a high equity ratio is almost always a good thing, so it pays to make yours as high as possible.

Equity Ratio Formula

The equity ratio formula is pretty straightforward: all you have to do is divide total company equity by total assets. Or:

• Equity ratio = total equity / total assets

Both of the necessary values to determine equity ratio should be found on company balance sheets. Total equity is the company’s net difference between its total assets and total liabilities. It is also sometimes referred to as shareholders’ equity if the company is primarily owned by its shareholders instead of company executives. Total assets are really the total estimated value of all combined company assets. These can include things like working equipment, products already created, infrastructure like office buildings or warehouses, and more.

What’s a “Good” Equity Ratio?

As mentioned earlier, a “good” equity ratio somewhat depends on your market conditions and volatility, as well as what management style best suits your business for future success. A low equity ratio just means that more of your assets are tied up with debt or that your investors don't outright on most of your company's stuff. This can often be a bad thing, but it's sometimes necessary for businesses to take on lots of debt in order to make big expansion moves or to build new infrastructure. This being said, a “good” equity ratio is usually high (i.e. a high percentage of 70% or above). This indicates that the company is primarily owned by its investors instead of indicating that most of its assets are owned by banks or other lending institutions. Furthermore, investors usually like to see conservative company management styles, with the sole exception of startups with a lot of potential (since they often need to grow quickly). Conservative company management styles usually provide consistent returns on investment, which investors love. They're typically in the investment business to make solid, consistent returns over time rather than to make lots of money fast. It may be a good idea to speak to one of our financial advisors here at Seek Capital to determine what a good equity ratio might be for your company given its unique financial situation and current assets. We can tell you whether your company is on the right track for a high equity ratio or give you advice about how to improve it.

Equity Ratio Example

Let’s take a look at an example of equity ratio calculation so you know how to use it for your own business. Imagine a business that has total company equity of $500,000. Meanwhile, its total assets are calculated to be valued at $750,000. By plugging in both of those values into the above formula, you get the equity ratio expressed as a percentage. In this case, it’s 67%. This is a little over two-thirds. Put in simpler terms, this means that about two-thirds of the company's total assets were paid with its own equity. A majority of its assets are not tied up in debt, which means that, in the event of company insolvency, two-thirds of the assets can immediately be liquidated in order to minimize financial hardship for shareholders or executives. Furthermore, this value shows that management has a reasonably conservative style. It’s not as conservative as it likely could be depending on its industry, but it’s far from risky at the same time.

What About Shareholder Equity Ratio?

You might also want to calculate shareholder equity ratio, which shows how much of a company’s assets are generated using equity shares as opposed to debt. It’s closely related to regular equity ratio. The lower the ratio’s result, the more debt a company has had to use in order to pay for its operations and assets (i.e. it’s usually a bad thing). For shareholders, high equity ratios are good since they indicate that they'll get better returns if a company is ever liquidated due to changing market conditions or bad management decisions. The shareholder’s equity ratio formula is almost identical to the normal equity ratio formula:

• shareholder equity ratio = total shareholder equity / total assets

In order to find shareholder equity, all you have to do is subtract liabilities from assets. This only applies, of course, to companies that have a lot of shareholders to begin with.

Summary

All in all, equity ratio can and should be used frequently to analyze your company or to analyze potential investments you're thinking of making. Equity ratio isn't to the end-all-be-all for financial analysis and can’t give you a full picture of a business just by itself. But it's a good way to get a snapshot of management style or current leverage, both of which can help clue you into other aspects of a given company. Be sure to contact Seek Capital if you have more questions and don’t hesitate to check out our other extensive guides on company analysis and financial formulas. Sources https://www.investopedia.com/terms/l/leverage.asp#:~:text=Leverage%20refers%20to%20the%20use,from%20an%20investment%20or%20project.&text=Companies%20use%20leverage%20to%20finance,attempt%20to%20increase%20shareholder%20value . https://www.investopedia.com/terms/s/shareholderequityratio.asp https://www.glassdoor.com/blog/company-equity/