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Equity Ratio: Definition, Formula, and Examples

Grab your balance sheet: We’re going to talk about the equity ratio. What is the equity ratio? It’s a number that helps you—and whoever is looking at your business financials—understand your company’s solvency in terms of the amount of debt you have on your books. Luckily, the equity ratio formula is simple: You just need to make sure that you have a few numbers handy.

In this guide, we’ll go through the equity ratio definition, what the equity ratio means for your business, and also review a few equity ratio examples. At the end of this, you’ll be able to calculate your business’s own equity ratio and know why it’s important to keep an eye on. Let’s get started.

What Is Equity Ratio?

The equity ratio is a way for your company to measure how much debt you have taken on relative to your assets. In other words, it shows how much investment you’ve put in and the amount of your company you own outright versus how much is financed by debt. It is a type of liquidity ratio.

As a business, you want a high equity ratio because it indicates that your business isn’t highly leveraged, which means you haven’t relied on a ton of debt to finance your asset requirements. It’s not the end of the world if you have a low equity ratio, but it may be a signal to those examining your business that you may not be solvent, or in other words, have a lot of financial runway to continue to finance your operations.

The elements of the equity ratio can be found on your company’s balance sheet.

Understanding Financial Leverage

Part of performing the operation that gives you your equity ratio is something called “leverage.” You may have heard this term in the context of corporations, like a “highly leveraged company,” but this can also apply to small businesses. The term is actually fairly fundamental: It describes how much debt you’ve used to finance your business.

A business is considered highly leveraged if they’ve relied heavily on debt. 

Why does this matter? Financial risk. Highly leveraged companies may be viewed as very risky candidates for business loans, or even risky candidates for investments, since they may not be able to pay the debt on their balance sheet.

Why the Equity Ratio Is Important

Like the debt-to-equity ratio, the equity ratio is important because it indicates your level of solvency. Solvency indicates whether a business can meet its debts and other financial obligations over the long-term.

A company with a high equity ratio is one that has less debt relative to its assets, which means that you’re not relying heavily on debt to finance your business. While having debt isn’t necessarily a deal-breaker, it’s a signal to those examining your financial profile that your company may not be totally solvent. 

Although this is an important ratio for investors or business lenders, it’s also important that you know your equity ratio—and understand what it means relative to your business. For instance, you may look at your balance sheet, but are you comfortable with the story it tells with how leveraged you are? The equity ratio is a straightforward way to understand this.

What Is the Equity Ratio Formula?

In order to calculate your equity ratio, use this equity ratio formula: 

Equity ratio = Total equity / Total assets

If you’re surprised that the formula is that simple, hopefully, that’s a good surprise! This is an easy number to calculate as long as you have your numbers handy from your balance sheet.

Elements of the Equity Ratio

There are two main elements of the equity ratio. Let’s go over what both mean:

Total equity: This number shows how much of your company is owned outright by your investors—and if you don’t have investors, that means you. (You’ve invested in your company after all.) It’s represented as a dollar figure since it’s the value of your investments.

Total assets: Total assets is a combination of two sources: debt and equity. Hopefully, you can start to see how this reveals how much debt your company has.

Equity Ratio Examples

Let’s go through a few equity ratio examples so you can see the equity ratio formula in action.

Equity Ratio Example 1

One company, the Widget Workshop, has been in business for a while—and has always been very careful with how much debt it takes on. That includes things such as how much they’ve spent on their business credit cards as well as how much they’ve borrowed in business loans.

Therefore, they have $200,000 in total equity and $285,000 in total assets. Let’s calculate their equity ratio:

Equity ratio = Total equity / Total assets

Equity ratio = $200,000 / $285,000

Equity ratio = 0.7

The Widget Workshop has a ratio of 0.7, or 70:100, or 70%.

What does this number say about the Widget Workshop? The owners of the Widget Workshop are seen as running their business conservatively. Because they’ve only taken on $85,000 of debt, relative to the $200,000 they own, they’re likely a solvent company that doesn’t represent a great deal of financial risk.

Equity Ratio Example 2

Let’s look at another example of the equity ratio formula in action. The Widget Workshop’s competitor, the Sprocket Shop, has been in business just as long—but they’ve made very different business decisions. In order to quickly grow, they’ve relied on more debt than the Widget Workshop. But they also own more equity. So, which shop has the better equity ratio?

Sprocket Shop has $400,000 in total equity and $825,000 in total assets.

Equity ratio = Total equity / Total assets

Equity ratio = $400,000 / $825,000

Equity ratio = 0.48

The Sprocket Shop has a ratio of 0.48, or 48:100, or 48%.

That means that the Sprocket Shop is more highly leveraged than the Widget Workshop. They’ve taken on more debt to finance their business, which means it’s not run quite as conservatively and will be viewed as riskier. Although they’ve made more profit, they may not be as solvent in their operations since they’ve taken on more debt relative to their equity.

What Is a Good Equity Ratio?

Generally, a business wants to shoot for an equity ratio of about 0.5, or 50%, which indicates that there’s more outright ownership in the business than debt. In other words, more is owned by the company itself than creditors. Companies that are above 50% are considered “conservative.” Companies below 50% are considered “leveraged.”

That said, certain industries are inherently more capital-intensive than others, which means that what’s considered a “good” equity ratio may be different and is contingent on specific industry benchmarks.

How to Change Your Equity Ratio

If you’re alarmed that your company is very leveraged and that your equity ratio is low, there are actions you can take to change your equity ratio. 

The simplest way to move your number is to rely less on debt. This will generally mean repaying as much of your outstanding debt as possible and finding ways to eliminate it. You can also invest more in your company outright, though this may be difficult if you are relying on debt. In that case, it may make more sense for your business to take that investment capital and pay off some of your loans.

Is an Equity Ratio of 0 Possible?

In theory, yes. If your company has entirely borrowed money to finance all operations, and you haven’t invested anything in the company, then the numerator in the equation would be 0—which means that no matter how much debt you have, the answer will come out to 0.

That’s generally not a good signal to anyone looking at your business financials, since it shows that you’re a risky candidate to repay creditors or provide returns to your investors. It also may mean that you can’t get credit at all, so there are no assets against which to secure your loan (and most loans require some form of collateral that they can liquidate in the case of default).

The Bottom Line

Hopefully, you now understand both what the equity ratio is as well as it’s importance. It’s a simple formula that can give you a nice bird’s eye view of the financial state of your company, and something you can easily calculate as you contemplate both investments and debt.

Remember that, just like cash flow margin or the debt-to-equity ratio, your equity ratio is a signal to anyone interested in your business financials about how conservatively you run your company, how leveraged you are, and, ultimately, how solvent you may be. This may tell the story of your company’s future, whichever way the dice may fall.

The post Equity Ratio: Definition, Formula, and Examples appeared first on Fundera Ledger.

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