The equity ratio is a financial metric that measures the amount of leverage used by a company. It uses investments in assets and the amount of equity to determine how well a company manages its debts and funds its asset requirements.
A low equity ratio means that the company primarily used debt to acquire assets, which is widely viewed as an indication of greater financial risk. Equity ratios with higher value generally indicate that a company’s effectively funded its asset requirements with a minimal amount of debt.
Equity ratio uses a company’s total assets (current and non-current) and total equity to help indicate how leveraged the company is: how effectively they fund asset requirements without using debt.
The formula is simple: Total Equity / Total Assets
Equity ratios that are .50 or below are considered leveraged companies; those with ratios of .50 and above are considered conservative, as they own more funding from equity than debt.
Formula for Equity Ratio
Let’s look at an example to get a better understanding of how the ratio works. For this example, Company XYZ’s total assets (current and non-current) are valued $50,000, and its total shareholder (or owner) equity amount is $22,000. Using the formula above:
The resulting ratio above is the sign of a company that has leveraged its debts. It holds slightly more debt ($28,000) than it does equity from shareholders, but only by $6,000.
Importance of an Equity Ratio Value
Any company with an equity ratio value that is .50 or below is considered a leveraged company. The higher the value, the less leveraged the company is. Conversely, a company with an equity ratio value that is .50 or above is considered a conservative company because they access more funding from shareholder equity than they do from debt.
Investors tend to look for companies that are in the conservative range because they are less risky; such companies know how to gather and fund asset requirements without incurring substantial debt. Lending institutions are also more likely to extend credit to companies with a higher ratio. The higher the ratio, the stronger the indication that money is managed effectively and that the business will be able to pay off its debts in a timely way.
A high ratio value also shows that a company is, all around, stronger financially and enjoys a greater long-term position of solvency than companies with lower ratios.
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