# Equity Ratio

**Meaning and definition of Equity ratio **

The **equity ratio** refers to a financial ratio indicative of the relative proportion of equity applied to finance the assets of a company. This ratio equity ratio is a variant of the debt-to-equity-ratio and is also, sometimes, referred as net worth to total assets ratio. The equity ratio communicates the shareholder’s funds to total assets in addition to indicating the long-term or prospective solvency position of the business.

**Calculating Equity Ratio **

The equity or proprietary ratio is calculated by dividing the shareholders’ funds by the total assets.

**Formula for Equity Ratio **

The formula used to calculate equity ratio is:

Equity Ratio = Shareholders funds / Total assets

**Example **

The equity ratio can be illustrated through the following example:

A company has shareholders funds worth $1,800,000 and total assets, which are equivalent to liabilities worth $3,000,000. The equity is, therefore, calculated as:

Equity Ratio = 1,800,000 / 3,000,000

This implies that of every $1 employed in the business, the contribution of shareholders is about 60 cents. The creditors’ contribution, therefore, would be 40 cents.

**Significance of Equity ratio **

The equity ratio throws light on a company’s overall financial strength. Besides, it is also treated as a test of the soundness of the capital structure. A higher equity ratio or a higher contribution of shareholders to the capital indicates a company’s better long-term solvency position. A low equity ratio, on the contrary, includes higher risk to the creditors.

**Importance of a reasonable equity ratio **

The reasons and importance of having a reasonable equity ratio for a company is explained as follows. Companies having a higher equity ratio have to pay less interest thus having more free cash on hand for future expansions, growth, and dividends. On the contrary, a company with a lower equity ratio is more prone to losses for a large portion of its earnings is spent in paying interests. Besides a higher equity ratio provides a freer access to capital at lower interest rates. A lower equity ratio, on the other hand, makes it difficult for a company to obtain loan from banks and other financial institutions. If, in ay case, they manage to get a loan, it is at comparatively higher interest rates.

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