Equity ratio definition
/What is the Equity Ratio?
The equity ratio measures the amount of leverage that a business employs. It does so by comparing the total investment in assets to the total amount of equity. If the outcome of the calculation is high, this implies that management has minimized the use of debt to fund its asset requirements, which represents a conservative way to run the entity. Conversely, a low ratio indicates that a large amount of debt was used to pay for the assets. In the latter case, management is relying on leverage to boost an organization’s return on assets (ROI). Leverage can generate a substantial boost in ROI, but also increases the risk of default, if a business does not have enough cash to make scheduled debt payments.
How to Calculate the Equity Ratio
To calculate the equity ratio, divide total equity by total assets (both found on the balance sheet). Total equity includes the recorded totals for common stock, preferred stock, additional paid-in capital, and retained earnings, minus treasury stock. Total assets includes all current assets and all long-term assets. The equity ratio formula is:
Total equity ÷ Total assets = Equity ratio
Example of the Equity Ratio
As an example of the equity ratio, ABC International has total equity of $500,000 and total assets of $750,000. This results in an equity ratio of 67%, and implies that 2/3 of the company's assets were paid for with equity. If the company’s cash flows are variable, then the 67% ratio might be considered rather high. However, if the company has a history of generating consistently positive and steady cash flow, it may be able to easily support a ratio of this size.
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Understanding the Equity Ratio
A low equity ratio is not necessarily bad. It means that, if the business is profitable, the return on investment is quite high, since investors did not have to invest an inordinate amount of funds in comparison to the return generated. However, if the company's results become unprofitable, the interest expense associated with the debt could quickly eliminate all cash reserves and thrust the company into bankruptcy. This scenario is not necessarily the case when interest rates are low, since it requires little cash flow to pay for ongoing interest costs.
A low equity ratio is easier for a business to sustain in an industry where sales and profits have minimal volatility over time. Conversely, a highly competitive industry with constantly changing market shares may be a bad place in which to have a low equity ratio; in this environment, it can be quite difficult to pay back debt.
Potential investors and creditors prefer to see a high equity ratio, since it implies that a company is conservatively managed, always pays its bills on time, and is not likely to become insolvent. Lenders are unlikely to lend additional money to a firm with a low equity ratio, since the incremental risk of doing so is too high, unless they can obtain collateral to reduce their risk.
How to Improve the Equity Ratio
There are several ways to achieve a lower equity ratio. The main goal is to reduce the amount of debt outstanding. One option is to sell more shares to investors, so that the resulting funds can be used to pay down debt. Another option is to collect accounts receivable more quickly, which frees up cash that can be used to pay down debt. Faster receivables turnover can be achieved by tightening credit terms, as well as by employing more aggressive collection activities. Another possibility is to reduce the investment in inventory, which also spins off cash. Inventory can be reduced by outsourcing production, or by installing a just-in-time production system that requires less on-hand inventory. A final option, though a difficult one to achieve, is to negotiate longer payment terms with suppliers. Most suppliers are unwilling to offer longer terms unless the company buys in large volume from them. In short, there are many options for improving the equity ratio.