Which ratio measures the percentage of assets financed by creditors rather than by shareholders?

What is an Equity Ratio?

The equity ratiois the solvency ratio that helps measure the value of the assets financed using the owner’s equity. It is calculated by dividing the company’s total equity by its total assets. It is a financial ratio used to measure the proportion of an owner’s investment used to finance the company’s assets. It indicates the proportion of the owner’s fund to the total fund invested in the business.

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• What is an Equity Ratio?
• Interpretation
• The Significance of Equity Ratio
• Recommended Articles
• What ratio measures the proportion of total assets financed by the firm's creditors?
• What ratio gives you the percentage of the company's total assets that are financed by creditors and lenders as opposed to the owners?
• What ratio measures the percentage of a company financing that comes from creditors and investors?
• What measures the percentage of total assets that creditors provide?

Traditionally it is believed that the higher the proportion of the owner’s fund the lower the degree of risk. The investors will get all the remaining assets left after paying off the liabilities.

Formula

The equity ratio is calculated as shareholders’ equity divided by total assets, and it is mathematically represented as,

Equity Ratio = Shareholder’s Equity / Total Asset

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For eg:
Source: Equity Ratio (wallstreetmojo.com)

Shareholders’ equity includes Equity share capitalShare capital refers to the funds raised by an organization by issuing the company's initial public offerings, common shares or preference stocks to the public. It appears as the owner's or shareholders' equity on the corporate balance sheet's liability side.read more, retained earnings,Retained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more treasury stockTreasury Stock is a stock repurchased by the issuance Company from its current shareholders that remains non-retired. Moreover, it is not considered while calculating the Company’s Earnings Per Share or dividends. read more, etc., and Total assets are the sum of all the non-current and current assets of the company. It should be equal to the sum of shareholders’ equity and the total liabilities.

Interpretation

• Since this ratio calculates the proportion of owners’ investment in the company’s total assets, a higher ratio is considered favorable for the companies.
• A higher level of investment by the shareholders attracts more investment by the potential shareholders as they think that the company is safe for investing as already, the level of investment by the investor is higher.
• Also, a higher investment level provides security to the creditors as it shows that the company is not that risky to deal with. They can lend funds thinking that the company will be able to pay off its debt easily.
• Companies having a higher equity ratio also suggest that the company has less financing and debt service cost as a higher proportion of assets are owned by equity shareholders. There is no financing cost, including interest in financing through equity share capital, compared to the cost incurred in debt financing and borrowing through banks and other institutions.
• If possible, companies should go for equity financingEquity financing is the process of the sale of an ownership interest to various investors to raise funds for business objectives. The money raised from the market does not have to be repaid, unlike debt financing which has a definite repayment schedule.read more rather than debt financing because equity financing is always economical as compared to debt financing because there are various financing & debt service costs associated with debt financing. It is mandatory to pay off such debts whether the business is in a good state.

Example

Let’s take an example of a company named jewels ltd involved in the manufacturing of jewelry whose balance sheet reported the following assets and liabilities:

• Current Assets:Current assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more $30,000
• Non-Current Assets: $70,000
• Shareholders’ Equity: $65,000
• Non-Current liabilities: $20,000
• Current Liabilities:Current Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc.read more $25,000

Total Assets = Current Assets + Non-Current AssetsNon-current assets are long-term assets bought to use in the business, and their benefits are likely to accrue for many years. These Assets reveal information about the company's investing activities and can be tangible or intangible. Examples include property, plant, equipment, land & building, bonds and stocks, patents, trademark.read more

= $100,000

Shareholders’ Equity = $65,000

Therefore,

Equity Ratio = Shareholder’s Equity / Total Asset

= 0.65

We can see that the equity ratio of the company is 0.65. This ratio is considered a healthy ratio as the company has much more investor funding than debt funding. The proportion of investors is 0.65% of the company’s total assets.

The Significance of Equity Ratio

• Conservative companies are less risky as compared to leveraged companies. A company that has an equity ratio greater than 50% is called a conservative company, whereas a company that has this ratio of less than 50% is called a leveraged firm. In the given example of jewels ltd, the company is conservative since the equity ratio is 0.65, i.e., Greater than 50%.
• Conservative companies have to pay dividends only if there is profit. Still, in the case of leveraged companies, interest has to be paid no matter whether the company is earning profits. The creditors and the investors prefer to lend and invest in a high Equity Ratio company because it reflects that the company is managed conservatively and pays off the creditors timely.
• So, the companies with higher equity ratios face less risk.
• Also, companies with a higher ratio are required to pay less financing costFinancing costs refer to interest payments and other expenses incurred by the company for the operations and working management. An enterprise often borrows money from different financing sources to run their operations in return for interest payments and capital gains.read more, thereby having more cash for future growth & expansions; on the other hand, companies with lower ratios have to pay more cash to pay off their interest and debt.
• It also reflects a company’s overall financial strength. It is also used to check whether the capital structure is sound. A higher ratio shows a higher contribution from the shareholders. It indicates that the company has a better long-term solvencySolvency of a company means its ability to meet the long term financial commitments, continue its operation in the foreseeable future and achieve long term growth. It indicates that the entity will conduct its business with ease.read more position, and on the other hand, there is a high risk to creditors in case of a lower ratio.

Conclusion

Equity Ratio calculates the proportion of total assets financed by the shareholders compared to the creditors. Generally, a higher ratio is preferred in the company as there is safety in paying debt and other liabilities. If more financing is done through equity, there is no liability for paying interest. The dividend is not an obligation. It is paid if the company is earning profits, but a low ratio can also be seen as a good result for the shareholders if the interest rate paid to creditors is less than the return earned on assets. Therefore it is advised to the potential investors and creditors that equity ratio calculation should be analyzed from every angle before making any decision while dealing with the company.

Recommended Articles

This article has been a guide to what equity ratio is. Here we discuss Equity Ratio calculation using its formula (shareholder’s equity / Total assets) with examples and analysis. You may also have a look at the following financial analysis articles –

• Solvency Ratio Formula
• Leverage Ratios Interpretation
• How to Calculate Debt to Equity Ratio?
• Equity Turnover Calculations