Financial ratios such as the equity ratio play an important role in financial statement analysis, because they are easy to calculate and provide a gauge for business performance. The equity ratio is a solvency ratio, providing insight into capital structure, the company’s assets, equity and the financial well-being of a business. Below are the advantages of this ratio and how it can be used to make decisions.
Equity Ratio Defined
The equity ratio is a simple calculation where total equity is divided by total assets. This ratio provides insight into the amount of equity used to finance operations and purchase capital equipment. Equity is calculated by subtracting total liabilities from total assets, both of which are found on the balance sheet. It also provides insight into the solvency of a business and an indication of capital structure. A low proportion of equity to assets is an indication that a business may have substantial debt, which would also result in a higher debt ratio. It is also an indication that business owners or shareholders have withdrawn equity from the company. The analytical benefits of this ratio should not be underestimated.
Equity Ratio Formula
The equity ratio formula is straightforward. It is calculated by taking total equity divided by total assets, at a single point in time. Total equity can be stockholder’s equity for a large corporation, or it can be owner’s equity in a sole proprietorship. Total assets are the sum of all current and non-current assets, ranging from cash and inventory to property, plant and equipment. The formula can be calculated for businesses large and small regardless of capital structure.
How is the Equity Ratio Used?
The ratio is used in management decision making and not in the day-to-day operations of a business. Rather, it gives an indication of financial leverage and the ability of a business to remain solvent during difficult times. Management is charged with managing the assets of a business and must fund capital expenditures using a sustainable capital structure. So, the equity ratio gives management insight, and it also gives business owners insight into the performance managers.
Accountants can use the equity ratio as a form of internal control over financial reporting. Tracking the ratio over time can give an indication, if there are errors present on the balance sheet. Accountants are also called on often to put together reports, helping senior leaders understand the financial condition of a company. Accountants can compare industry benchmarks for the equity ratio and provide that information to senior leaders, so that informed business decisions can be made.
Why is the Equity Ratio Important?
Ratio analysis is quick and can provide a wealth of information, which is why the equity ratio is a viable tool. Creditors and investors may also be interested in this metric, especially if a company is struggling to meet its obligations and fund operations from existing sales. If the equity ratio indicates that a company is misusing financial leverage, it can serve as a wake-up call for all relevant stakeholders, as a highly-leveraged company is very sensitive to rising interest costs and may not be able to meet their obligations. It can also serve as a baseline performance metric for changes in business strategy.
Given that many businesses tend to use too much debt financing for operations, measures of equity to assets is an important measure of fiscal responsibility. If management has over-borrowed, business owners and shareholders can perform a ratio analysis and challenge managements actions, if needed. Financial ratios provide an objective measure the stakeholders can use to compare to other businesses in the industry, to determine the appropriate capital structure.
A low equity ratio typically shows assets are acquired through a high use of debt and may indicate a higher financial risk as highly leveraged companies are more at risk to not being able to pay their debt. Companies with higher equity ratios generally indicate that a company is funding asset with a minimal amount of debt.
While simple to calculate, the equity ratio is one of the most effective metrics for measuring solvency. It gives business leaders insight into leverage, capital structure and how effectively management is using equity and assets. This metric and other financial ratios make business management easier.