What is Equity Ratio?
The equity ratio is an accounting ratio. It compares the entire equity in the company to the total assets to determine how much of the assets are financed by the owners’ capital.
The equity ratio emphasizes key financial elements of a solvent and long-term company. The ratio indicates what percent of a company’s total assets are owned outright by investors. In other words, after all of the liabilities have been paid off, the residual assets will be distributed to the investors.
It indirectly reflects the company’s debt leverage. The inverse of this formula shows how much debt was used to fund assets.
Equity Ratio Formula
The formula for the Equity Ratio is:
Equity Ratio = Total Equity / Total Assets
Total Equity = Total Assets – Total Liabilities or Share Capital + Retained Earnings + Other Reserves
Total Assets = Tangible Assets + Intangible Assets
How to Calculate Equity Ratio?
The following illustration explain the calculation of Equity Ratio:
|Short Term Liabilities
|Long Term Liabilities
(Tangible Assets + Intangible Assets)
(Rs 12,00,000 + Rs 6,00,000)
(Short Term Liabilities + Long Term Liabilities)
(Rs 2,00,000 + Rs 7,00,000)
(Total Assets – Total Liabilities)
(Rs 18,00,000 – Rs 9,00,000)
(Total Equity / Total Assets)
(Rs 9,00,000 / Rs 18,00,000)
Half of the assets were funded by equity. If the company has a steady flow of revenue and cash flow then 50% will not have a negative impact.
However, if the cash flows are not steady then 0.50 would be a high ratio.
Interpretation of Equity Ratio
Low Equity Ratio
A low equity ratio means that if a business is profitable, the return on investment is high. This is because there was no need for investors to invest in significant funds in comparison to the revenue generated. However, if the company’s results become unprofitable, the debt’s interest expense could swiftly deplete the company’s cash reserves. If such a situation continues it could result in the insolvency of the company. When interest rates are low, this situation is less likely because with a lower cash outflow the company can cover its recurring interest costs.
In an industry where sales and profits are relatively stable over time and is easier to maintain. In contrast, highly competitive industry with frequently shifting market shares may face difficulty to repay debt. Moreover, it could be difficult to maintain a low equity ratio.
High Equity Ratio
A high equity ratio is preferred by potential investors and creditors. It indicates that a company is well-managed, pays its debts on time, and is unlikely to go insolvent. Lenders are hesitant to lend more money to a company with a low equity ratio since the risk of doing so is too high. However, the lenders would proceed with investments with collateral to mitigate the risk.
Owing to the interest costs associated with loan financing, equity financing is generally substantially less expensive than debt financing. Companies with higher equity ratios should have cheaper debt payments and financing expenses than those with lower ratios.
How to Improve Equity Ratio?
There are various methods for lowering the equity ratio. The basic goal is to lower the total amount of debt owed. One alternative is to sell more shares to investors and use this investment towards debt repayment. Another approach is to collect accounts receivables more rapidly, which frees up funds for debt repayment. Credit terms might be tightened and more aggressive collection actions can be used to increase receivables turnover. Another option is to reduce inventory investment and manage production lines effectively. Outsourcing production or using a just-in-time production method that requires less on-hand inventory can help minimise inventory.
Negotiating extended payment terms with suppliers is a final possibility. Unless the organisation buys in significant quantities, most suppliers are unwilling to give longer terms. To summarise, there are numerous ways to improve.
Companies should prefer stock financing over debt financing. Equity financing is always more cost effective than debt financing. Further, this debt comes with a variety of financing and debt servicing fees. Moreover, whether the firm is in excellent shape or not, it is necessary to pay off such debts.