What is Equity Ratio?
The equity ratio is a way for your company to measure how much debt you have taken on relative to your assets.
In other words, it shows how much investment you’ve put in and the amount of your company you own outright versus how much is financed by debt. It is a type of liquidity ratio.
It’s an investment leverage or solvency ratio that measures the amount of assets that are financed by owners’ investments by comparing the entire equity within the company to the whole assets.
This ratio highlights two important financial aspects of a solvent and sustainable business. The primary component shows what quantity of the whole company assets is owned outright by the investors.
In other words, finally of the liabilities are paid off, the investors will find yourself with the remaining assets.
The second component inside out shows how leveraged the firm is with debt.
The equity ratio measures what proportion of a firm’s assets were financed by investors.
In other words, this is often the investors’ stake within the company.
This is often what they’re on the hook for. The converse of this calculation shows the quantity of assets that were financed by debt.
Companies with higher equity ratios show new investors and creditors that investors believe the organization and are willing to finance it with their investments.
Advantage of Debt to Equity Ratio
- With the help of cash flow, A firm can easily serve its debt obligations.
- Using the leverage to increase equity returns.
- Due to using of debt instead of equity, the equity account is smaller, and therefore return on equity is higher.
- It provides greater protection to its money
Disadvantage of Debt to Equity Ratio
- It differs from industries to industries so consistency is not sure.
Formula Equity Ratio
To evaluate the equity ratio divide total equity by total assets. In another simple language, all of the assets and equity represented on the balance sheet are included in the equity ratio calculation.
Analysis and Interpretation of Equity Ratio
The Equity Ratio may be a good indicator of the extent of leverage utilized by an organization.
It measures the proportion of the entire assets that are financed by stockholders, as against creditors.
A low this ratio will produce good results for stockholders as long because the company earns a rate of return on assets that are greater than the rate of interest paid to creditors
In general, higher equity ratios are generally favorable for companies. this is often usually the case for several reasons.
Higher investment levels by shareholders show potential shareholders that the corporate is worth investing in since numerous investors are willing to finance the organization.
A higher ratio also shows potential creditors that the firm is more sustainable and less risky to lend future loans.
Equity financing generally is far cheaper than debt financing due to the interest expenses associated with debt financing.
A high value of this ratio should have less financing and debt service costs than companies with lower ratios.
As with all ratios, they’re dependent on the industry. The performance of the ratio depends upon industry standards and benchmarks.
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Example of Equity Ratio
Ram’s Tech Company may be new start-ups with a variety of various investors. Ram is trying to find additional financing to assist grow the firm, so he talks to his business partners about financing options.
Ram’s total assets are reported at $150,000 and his total liabilities are $50,000. supported the accounting equation, we are able to assume the whole equity is $100,000. Here is Ram’s equity ratio.
As you’ll be able to see, Ram’s ratio is 0.67. This suggests that investors instead of debt are currently funding more assets.
67 percent of the company’s assets are owned by shareholders and not creditors. Reckoning on the industry, this is often a healthy ratio.