Definition: The equity ratio is a financial ratio that measures equity as a percentage of total assets. This shows the proportion of assets that are owned outright by the shareholders of the company. In other words, the equity ratio calculates the ratio of total assets that were financed by investors.
The equity ratio is calculated by dividing total equity by total assets. The result shows how much of the firm assets the shareholders own. Let’s take a look at an example.
Scott’s Furniture Warehouse sells discount furniture to the public. Scott and several investors believe in his business strategy and are willing to put $150,000 into the business. The total assets of the startup company are on the books for $200,000.
Scott’s equity ratio would be calculated by dividing 150,000 by 200,000 resulting in a .75 ratio. This means that 75 percent of the company’s total assets are contributed and “owned” by the shareholders of the company.
The remaining assets must have been financed through debt. You can calculate this by using the debt ratio.
The equity, debt and debt-to-equity ratios are all important calculations that show how leveraged a business is. This is important for management to consider when planning big capital improvements or expansions.
What Does Equity Ratio Mean?
Using debt to finance expansions could discourage investors because the profits will be lowered due to increased interest payments. Also, creditors will eventually start charging higher rates, as the growing debt might not be fully collateralized by the company assts.
On the other hand, too much equity financing can dilute interests and discourage investors as well.