By viewing your total equity as a proportion of your total assets, you can gauge your business’s use of debt. This is important to know because it helps you determine how risky or conservative you’re being with your money.
Of course, that’s not all there is to know about equity ratios. In this post, we’ll help you fully understand how to calculate your equity ratio, when it’s useful, and how you can use it.
What is the Equity Ratio?
As mentioned, the equity ratio definition is total equity divided by total assets. Expressed as a formula, it looks like this:
Total Equity ÷ Total Assets = Equity Ratio
As a quick review,
total assets are the things your business owns that you expect will yield an economic benefit. This includes items such as inventory, machinery, trademarks, and anything else of economic value.
Total equity is equal to your total assets minus your total liabilities
. Put another way, total equity is what’s left when you subtract everything you own by everything you owe.
For example, let’s say you decided to finance the purchase of your home. After the purchase, your total equity is equal to the value of the home minus the remaining balance on your home mortgage.
Compared to calculating the equity ratio of your home, doing it for your business is a little more complicated. Still, the same principles apply, as you’ll see in the next section.
How to Calculate Your Equity Ratio
As you’ve seen, the equity ratio formula is fairly simple, so calculating it is really just a matter of compiling the inputs.
If your books are up-to-date
, you can pull reports that show your current assets and total equity.
All you’ll need is your company’s balance sheet
; once you have that, simply plug your total assets and total equity into the equation. If you’re looking to compare your equity ratio to public companies within your industry, you can pull this information on them from Yahoo Finance.
According to the Corporate Finance Institute
companies with equity ratios below 0.50 are considered leveraged. Conversely, companies with ratios above 0.50 are considered conservative.
That said, these ratios vary based on industry and it’s not necessarily wrong to have an equity ratio above or below 0.50.
When Is The Equity Ratio Useful?
All financial ratios, like the equity ratio, express certain financial properties of a business as a proportion.
Expressing things as proportions is useful because it allows you to meaningfully compare one business’s properties to another. When you know how your equity ratio compares to other similar companies, you can assess the risk of your and your competitor’s capital structure.
For example, let’s say your competitor has significantly more assets than you and your investors are pressuring you to keep up. In addition, let’s also say that you know your competitor’s ratio is far lower than industry-standard.
With your competitor’s equity ratio, you can show your investors that while your competitor has more assets, they’re also taking on more debt.
If your investors are okay with raising debt, that’s another subject. The point is, in this scenario, the equity ratio provides useful information necessary for making good decisions about financing.
In addition to its usefulness for making financing decisions, your equity ratio influences your ability to raise more debt.
This is because a low equity ratio means your company has more debt. On average, the more debt a borrower has, the more risky it is to lend money to the borrower.
To compensate the lender for this additional risk, the borrower will typically have to pay more.
As with most financial ratios, the equity ratio is best used when you want to compare your company to others in your industry. This is because different industries have varying capital requirements and competitive forces.
Both of these factors have an industry-wide influence on equity ratios.
Conclusion: Equity Ratios Answer High-Level Debt Questions
What amount of debt has your business acquired, and is it too much, or not enough? When and how much debt should you raise for your business in the long term? These are the questions that this type of ratio helps you answer.
Unfortunately, equity ratios don’t answer all your questions about your business.
For example, let’s say growth has stalled and you’re considering debt financing to purchase revenue-generating assets
. You see your equity ratio is high so you consider debt financing.
This may be the correct move but before pursuing it, you should see how efficiently your assets are being used. For this, you can use the asset turnover ratio.
All this to say, the equity ratio can’t—nor should it be expected to—provide all the information needed to make a good decision.