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
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.