A company’s equity ratio is one of the most important key figures for investors, banks and other lenders – and for the entrepreneur himself. How to calculate the equity / assets ratio.
So, what is equity ratio used for?
Since a company’s equity ratio is usually a good indicator of the company’s long – term ability to pay, it is used in many different contexts. Investors want to know the equity / assets ratio for them to dare to invest in a company, banks and lenders use it in their risk calculation when companies apply for loans – and the companies themselves use it as a way to calculate what their financial stability looks like.
It is not surprising to have a lower equity ratio when expanding the company or investing heavily in new investments. Over time, however, a high equity ratio is preferable.
What does equity ratio mean?
Equity ratio is a percentage measure of how large a share of a company’s assets is financed with equity, ie the company’s own money.
If a company has financed all assets with equity, this means that the equity / assets ratio is 100%. Everything is paid and there are no loans to repay.
If all assets are financed with borrowed capital, this means instead that the equity / assets ratio is 0%.
Equity / assets ratio is thus a key figure that is important for understanding a company’s long-term ability to pay. It is thus a good key figure to examine in a fundamental analysis.
Should a company with a high equity ratio for any reason suffer financial difficulties, assets can be sold off or mortgaged to pay off debts.
A company with a lower equity ratio, ie a company with large debts, has few assets to sell from because they are in practice financed with borrowed capital.
In this way, the long-term ability to pay is worse at a low equity ratio.
How to calculate equity / assets ratio?
You calculate the equity / assets ratio by dividing the company’s equity with the company’s assets.
Equity / assets = equity / assets ratio in%
A company has equity of $100,000 and assets of $300,000.
100,000 / 300,000 = 0.33 or 33%.
The company’s equity ratio is thus 33%, ie two thirds of the company’s assets are paid with loans.
There are several ways to measure a company’s equity ratio. The following formula for solvency is the most common:
Formula: Equity ratio (%) = (Adjusted equity / total capital) x 100
Adjusted equity is a better measure of shareholders’ capital than equity. This is calculated according to:
Adjusted equity = Equity + (Untaxed reserves × (1 – tax rate))
Is high equity ratio good or bad?
If you only look at the direct risk in a company, a higher equity / assets ratio is better than a lower one.
The risk that a company with a high equity / assets ratio will go bankrupt in bad times is simply lower than for a company with a low equity / assets ratio.
As an example, you can look at your own finances.
Do you have a buffer of saved money that you can take off in times of crisis or do you live on credit and installments? Are you mortgaged high or low in relation to your own assets?
At the same time, it is not black or white. For the vast majority of companies, not least those listed on the stock exchange, have stated growth targets.
One way to grow a company is to produce more, faster and more efficiently. For this to be possible, investments in new assets are often required.
For a small farm, such an asset could be a new tractor. If we instead look at a publisher of computer games, an asset could be a new game studio.
This type of purchase is often costly and unless you are willing to save a number of years it is not certain that there is money in the coffers to finance it without taking out a loan.
With the help of loans, you can thus finance growth.
The goal is then, of course, that the profit the new asset contributes to should be large enough to both pay off the loans and at the same time contribute to an increased profit.
As you can see, a high equity ratio is not always automatically better.
Small companies that grow fast often have a lower equity ratio than large stable ones that do not grow at the same rate.
How high an equity ratio should a company have?
The answer to that question is again “it depends”. If you look at the Swedish stock market, the average is around 30-50%.
But as I said – low equity ratio does not necessarily have to be negative if growth is strong at the same time and the company is relatively new.
What you should keep an eye on when you do your analysis is therefore how the equity / assets ratio changes year after year.
It is desirable that the equity / assets ratio improves in the long term or is unchanged.
If the equity / assets ratio gradually deteriorates, it may be a signal that the company is not earning enough money to cover its debts – or that the dividend to the owners is too high and therefore eats away at the profit.
How to improve the equity / assets ratio?
A company’s equity / assets ratio is improved by reducing borrowing in relation to equity.
This is done by paying off loans, either with the help of the profit that the business generates or by the owners contributing their own money to the company.
Here, the goal is of course that the company as such should generate profit, as it is the only sustainable one in the long run.
The equity / assets ratio can only increase in three ways:
- By the company generating profit and this is reinvested in the company
- By amortization of debts
- By the owners contributing funds (for example through a new share issue)
When the company makes a loss, equity decreases and the equity / assets ratio decreases. In this way, the company’s equity ratio determines how long the company’s results can be negative before bankruptcy.
At the same time, equity is an expensive way of financing the business as the owners’ required rate of return is often higher than the interest rate on bank loans.
For that reason, a common solvency target is around 30–40 percent.
The equity / assets ratio should not be confused with the debt / equity ratio, which is related to the equity / assets ratio but which is used specifically to calculate the company’s financial risk (interest rate sensitivity).
Good or bad equity ratio can occur in several different ways
It is not always certain that a good equity ratio is favorable for the company.
High solvency can also be a consequence of a lack of development work and insufficient or non-existent investments that have led to low borrowing, which in turn turns out to be a “good” solvency.
Poor equity / assets ratio is often due to the company making a loss, but it can also be a result of strong expansion and investments, which is often both natural and necessary in certain periods.
During a growth phase, therefore, a temporary deterioration in the equity / assets ratio may be acceptable.
Impaired equity / assets ratio at the same time as poor growth, on the other hand, is often a warning signal.
What is a good ratio?
Looking at the equity ratio without having an understanding of the company and its industry as a whole does not really say much.
One of the basic preconditions for running a company is that in the long run you can create a better return on invested capital than a normal bank interest rate.
Therefore, a low equity ratio does not have to be a problem for a company that grows and shows increasing profitability.
The better opportunity a company has for growth, the greater the amount of loans it is justified to take, which means that a low equity ratio does not have to be negative.
But when a company for a long time has not managed to generate sufficient growth or increased profitability while the equity ratio continues to fall, it can be a sign that the company has serious problems.
Exactly what is a “good” figure for solvency depends on a number of factors. Above all, you should compare the company with other companies of similar size in the same industry.
Smaller companies in different types of consulting operations, for example, often have a high equity ratio of around 60–70% as this type of company does not need as much capital to start and expand its operations.
This can be compared with, for example, Real Estate Development where most companies have a very low equity ratio of around 30% or even lower as large amounts of capital are required to build and develop properties.
If you notice that a company’s equity / assets ratio changes greatly from one year to another, it may be worth checking what it is due to, often it can be a question of one-off events that in the long run do not affect the company’s ability to generate profit.
How do you calculate a company’s equity ratio?
The figures you need to calculate a company’s equity ratio are equity and total assets (total assets). This information can be found in the company’s balance sheet.
By dividing equity by the balance sheet total, you get a number that you then convert to a percentage to get the equity ratio.
Cash liquidity is the short-term equivalent
If equity / assets ratio is used as a measure of long-term solvency, cash liquidity is a measure of short-term solvency. This key figure can also be important for banks and lenders – and especially for companies themselves.
A good cash liquidity must be 100 percent or more, which simply means that the company can meet its short-term financial commitments if necessary.
The formula for calculating cash liquidity is:(Current assets – Inventories) / Current liabilities * 100
Examples of current assets are accounts receivable, stocked items and cash and cash equivalents in various forms.
However, inventories are excluded here as the purpose is to ensure the assets that can be used quickly to pay off the current liabilities.