Equity Ratio - What Is It, Interpretation, Significance, Example (2024)

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.

• 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 onequity 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.

Formula

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 capital, retained earnings, treasury stock, 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.

Interpretation

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 goodequity 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 onequity 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 financing 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.

Example

Let us understand the concept of goodequity 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: $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 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 ratioanalysis, 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.

Significance

The significance or importance of the equity ratioanalysis 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 economicequity 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 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 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 solvency 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 economicequity 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)

Recommended Articles

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 –

• Solvency Ratio Formula
• Leverage Ratios Interpretation
• How to Calculate Debt to Equity Ratio?
• Equity Turnover Calculations