The shareholder equity ratio is a ratio that shows the amount of a company’s assets that have been financed using the owner’s equity instead of debt. It shows the portion of shareholders’ funds that have been used to finance the assets of the company, and it indicates the value that owners will get if the company is liquidated.
The shareholder equity ratio is calculated by dividing the shareholder’s equity by the total assets (current and non-current assets) of the company. The figures required to calculate the shareholder equity ratio are available on the company’s balance sheet.
A low shareholder equity ratio indicates that the company has taken on more debt than shareholder’s equity to finance its assets. In contrast, a higher shareholder equity ratio shows that a higher number of assets are financed by the shareholders than borrowed money.
The shareholder equity ratio is the proportion of a company’s assets that are financed using shareholder’s funds.
It represents the shareholder’s claim on the company’s assets if the company is liquidated and all debts are paid.
A higher shareholder equity ratio is desirable since it indicates that a higher proportion of assets are financed using shareholder’s equity rather than borrowed money.
Understanding the Shareholder Equity Ratio
The shareholder equity ratio shows the level of a company’s reliance on borrowed funds. It shows the proportion of equity that is used to finance a company’s assets in relation to borrowed funds. Since the ratio indicates the proportion of the owner’s equity in the total value of the company’s assets, a higher ratio is desirable.
A higher proportion of owner’s funding compared to debt funding attracts potential investors who are looking for viable companies to invest in. For creditors, a higher shareholder equity ratio is attractive since it shows the company is financially stable and should be able to pay off any debts advanced to it.
Also, a higher ratio indicates that the company incurs less debt service costs since equity shareholders finance a higher portion of the assets. Shareholder equity does not incur any financing cost for providing capital.
What is Shareholder Equity?
Shareholder equity represents the value that is attributable to shareholders of a company if its assets are liquidated, and all debts are paid. It is obtained by finding the difference between total assets and total liabilities recorded in the balance sheet for the specific financial period. The total assets component comprises the current assets (such as inventory and accounts receivable) and non-current assets (such as goodwill, equipment, and land).
On the other hand, the total liabilities are the sum of short-term liabilities (such as accrued expenses and accounts payable) and long-term liabilities (due in more than one year, such as deferred income taxes and bonds payable).
The value of equity can either be positive or negative, where positive equity means that the company owns sufficient assets to meets its liabilities, and negative equity shows that the value of liabilities exceeds the value of assets, rendering the company a high-risk investment.
How to Calculate Shareholder Equity Ratio
The formula for calculating shareholder equity is indicated as follows:
Shareholder Equity Ratio = Shareholder’s Equity / Total Assets
The ratio can be expressed as a percentage or number to show the proportion of a business that is financed by the owner’s equity compared to borrowed money. It is the total of share capital and retained earnings/reserved profits, less treasury stock.
Total assets equal the sum of non-current and current assets, and it is equal to the sum of shareholder’s equity and total liabilities. After calculating the ratio, it can be compared with the ratio of other companies within the industry to rank its relative performance.
If a company has an equity ratio that is greater than 50%, it is considered a conservative company. A company whose shareholder equity ratio is less than 50% is considered to be a leveraged company.
Investors are more interested in conservative companies than a leveraged company because such companies pay less financing costs, leaving more cash flow to finance future growth and expansion, and dividend distribution. A conservative company has a stronger solvency position, and it will be able to pay off its debts on time.
For comparison, a highly leveraged company carries a higher risk than a conservative company since it will use more cash to pay off its debt obligations, and if the company is liquidated, shareholders may have nothing left after paying off all debts.
Assume that ABC Limited owns total assets amounting to $1 million, while the total liabilities amount to $250,000. Also, the current value of shareholder equity equals $700,000. Using these values, we can calculate the shareholder equity ratio as follows:
Equity Ratio = $700,000 / $1,000,000
Equity Ratio = 0.7 or 70%
Therefore, ABC Limited shows an equity ratio of 0.7 or 70%, which indicates that 70% of the company’s assets are financed using shareholder equity, while the remaining proportion is financed by debt.
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