The equity ratio is a leverage ratio that measures the portion of company resources that are funded by contributions of its equity participants and its earnings. Companies with a high equity ratio are known as “conservative” companies.
The equity ratio is a leverage ratio that measures the portion of company resources that are funded by contributions of its equity participants and its earnings. Companies with a high equity ratio are known as “conservative” companies.
The formula in computing for the equity ratio is given below. Stockholders' equity (SHE) and total assets are both found in a company's balance sheet.
| Equity ratio | = | SHE |
| Total assets | ||
| or simply: | ||
| Equity ratio | = | Equity |
| Assets |
Total assets come from two sources: debt and equity. Hence, the portion that is not funded by debt is certainly the portion funded by equity. Thus, the equity ratio can also be computed using the following formula:
Equity ratio = 1 – Debt ratio
The following items have been extracted from ZBE Company’s balance sheet.
| Current assets | 5,600,000 |
| Non-current assets | 16,100,000 |
| Total assets | 21,700,000 |
| Total liabilities | 6,900,000 |
| Stockholders' equity | 14,800,000 |
| Total liabilities and equity | 21,700,000 |
The above amounts will result in an equity ratio of 68.2%.
| Equity ratio | = | Equity / Assets |
| = | 14,800 / 21,700 | |
| = | 68.2% |
Also, we can easily compute for the equity ratio if we know the debt ratio. The debt ratio in the problem above is equal to 31.8% (debt of 6,900 divided by assets of 21,700). Using the debt ratio, we can readily compute for the equity ratio.
| Equity ratio | = | 1 - Debt ratio |
| = | 1 - .318 | |
| = | .682 or 68.2% |
The equity ratio is a leverage ratio that measures the portion of assets funded by equity. Companies with equity ratio of more than 50% are known as conservative companies. A conservative company’s equity ratio is higher than its debt ratio -- meaning, the business makes use of more of equity and less of debt in its funding. In the above example, ZBE Company is a conservative firm.
When a company’s equity ratio is less than 50% (i.e. debt ratio is higher than equity ratio), it is known as a leveraged firm. Conservative companies are considered less risky compared to leveraged companies. Leveraged companies pay more interest on loans while conservative companies pay more dividends to stockholders. Businesses are contractually required to pay fixed interest regardless of operating outcome – whether they earn income or not. However, the payment of dividends is dependent upon the company’s earnings and the board’s decision. For that, companies with higher equity ratios are faced with less risk.
The equity ratio is a leverage metric. The higher the equity ratio, the more conservative the business is. Equity is generally safer than debt as they do not incur interest; plus, distribution of dividends is discretionary.
