Equity Ratio or Shareholder Equity Ratio is a measure of a company’s assets coming from the equity of the shareholder rather than taking on debt. A lower value of equity ratio indicates greater debt used by a company to finance its assets. Additionally, the equity ratio also showcases the value shareholders would receive in the event of the company being forced into liquidation.
The shareholder equity ratio or debt-to-equity ratio is a percentage value calculated by dividing the equity of a shareholder by the total assets owned by a company. We shall go through these aspects in detail.
Equity Ratio: Key Takeaways
- The equity ratio indicates how much a company’s assets come from buying stocks rather than borrowing capital.
- It is also a measure of the long-term financial stability of a company.
- A greater value of debt-to-equity ratio or shareholder equity ratio showcases that greater assets of the company are funded by stock investments or equity rather than debt.
- Figures recorded on a company’s balance sheet are used to calculate the shareholder equity ratio.
Equity Ratio: Meaning and Definition
Equity ratio, also known as debt-to-equity ratio, is a financial ratio used to calculate the percentage value of the assets of a company that are financed by equity and not by borrowing money. Conversely, it calculates the percentage value of a company’s assets financed by debt and not equity.
The shareholder equity ratio is related to leveraging and is thus called gearing, risk or leverage. It simply represents a ratio between the equity and the total assets of a company or a ratio between debt and equity. Different interpretations present different ways to calculate an equity ratio.
All the values required to calculate an equity ratio including total assets, total debt, and total liabilities are found in the book value or balance sheet of a company. Further, market values available can also be used to calculate the equity ratio.
The Calculative Formula for Equity Ratio
The shareholder equity ratio can easily be calculated by using the given formula:
Equity Ratio (ER) = Total Equity of Shareholder (E) / Total Assets of the company (A)
The total shareholder equity value can be found by going through the balance sheet and using the following equation:
Asset (A) = Equity (E) + Liability (L)
Interpretation of Equity Ratio
Besides the shareholder equity ratio formula mentioned above, the equity ratio is generally a ratio or proportion between debt and equity. However, depending on what is classified as debt, the ratio can take several forms. This is because there are different interpretations of debt.
The ratio would then look like either of these:
- Total Debt to Equity Ratio given by Total Debt/Equity
Total Debt-to-equity ratio represents a measure of the future obligations of a company concerning equity. Total debt incorporates both short-term debt and long-term debt including those long-term debts that have become short-term as they are nearing maturity. This long-term debt becoming short-term is classified as the current portion of long-term debt.
However, it may not showcase the true nature if in the debt only such liabilities as visible on the balance sheet are used that are labeled “debt” on the balance sheet. It is thus important to include accrual accounts such as unearned revenue in addition to actual borrowings or debt.
On a balance sheet, debt (liabilities) plus total equity is equal to assets i.e. A = D + E (thus, D = A – E or E = A – D). Thus, debt to equity (D / E) in terms of asset or debt can be given as:
D / E = D / A – D or A – E / E
- Long-Term Debt to Equity Ratio given by Long-Term Debt/Equity
A popular iteration of the equity ratio comes forward as the long-term debt-to-equity ratio. This ratio uses only the actual long-term debt as the numerator and excludes the current portion of the long-term debt or such long-term debt that has become short because of the nearness of maturity.
- Total Liabilities to Equity Ratio given by Liabilities/Equity
A ratio similar to the long-term debt-to-equity ratio is the Debt-to-Capital ratio (D/C) or the Total Liabilities-to-Equity ratio. Here capital represents the sum of equity and debt and is given by:
D-C Ratio = Total Liabilities / Total Capital = Debt / Debt + Equity.
Using this formula, we can find a relation between the Debt-to-Equity ratio (DE) and the Debt-to-Capital ratio (DC). It is given by:
DC= D / D+E = DE / 1+DE
Now, the Debt-to-Total Asset ratio is given as follows:
DA = Total liability / Total asset
= Debt / Equity + Debt + Non-financial liabilities
As the increase in non-financial liabilities decreases this ratio, it is a problematic leverage. However, it is very commonly used. A similar ratio to it is the Capital Adequacy or the Equity-to-Total Asset ratio (or Equity to Risk-Weighted Assets).
Here is an example of the Equity Ratio
Say that one wishes to invest in XYZ Incorporation Limited and thus needs to understand the current debt situation and financial strength of this company. For this, one would need to find the debt-to-equity ratio.
From the company’s balance sheet, one finds that the total assets value is $120,000 whereas the total liabilities value is $60,000 at the year-end. Let us break down this data to calculate the equity ratio by using these formulas.
Equity = Asset – Liabilities and Equity Ratio = Equity / Asset
E = $120,000 – $60,000 = $60,000
ER = $60,000 / $120,000 = 1 / 2 or 0.5 (or, 50%)
Thus, we can find that the company has financed half of its assets with equity which is a good indicator. However, since it’s only half, one may want to look for other options to invest in companies with a higher equity ratio or can invest in this one at a risk based on other factors.
What is the Importance of the Equity Ratio?
An equity ratio is significant in identifying the total assets, total debt, liabilities and assets of the company. It helps keep a check on the balance sheet and promotes responsible financial management.
Suppose a company pays all its liabilities by selling all its assets for cash then the remaining cash is called the equity of the company. Now the equity of a shareholder of this company will be the sum of its stock value, paid-in capital and the earnings retained. This sum is called the true value of a business.
An equity ratio of 100% shows that the company has financed all its assets with equity and no debt. A decreasing ratio would show a decreasing trend in financing with equity and an increasing trend in financing with debt. Thus, an equity ratio is important in identifying the financing portfolio of a company’s assets.
It facilitates lower borrowings and greater investments for more financial gains and long-term stability. An equity ratio is instrumental in understanding the financial strength of a company and its current debt situation.
A Good Equity Ratio
A good equity ratio is representative of the good financial strength of a company. Equity ratios vary from industry to industry.
However, as a general rule of thumb, all companies, businesses and financial entities aim for at least a 50% equity ratio that is considered well and good. Companies with an equity ratio between 50% and 80% are considered conservative whereas those with an equity ratio between 20% and 40% are considered leveraged.
A bad equity ratio indicates that a company is financed with financial borrowings and debt instead of funds from shareholders.
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Equity Ratio FAQs
Q1. What is the equities ratio?
Ans: Equities ratio or equity ratio represents the percentage of a company's assets that are financed by equity rather than borrowing money or debt. Thus, it is an indicator of the current debt situation of a company or business and its financial strength.
Q2. How to calculate the equity ratio?
Ans: A simple way to calculate the equity ratio for a company or business is to divide its equity value by the total assets owned by the company. These values are easily found on the balance sheet of a company.
Q3. What does one crore for one equity mean?
Ans: When an investor mentions one crore for one equity, it means he or she would own 1% of the company value in exchange for their investment value. Here the investment value would be 1 crore. This means the company would be valued at 100 crores (1 crore divided by 1%).
