Equity Ratio: Meaning, Formula, Calculation, & Benefits

Do you want to understand a company’s stability and foundational strength beyond just looking at profits? Equity ratio might just be the right financial tool for you. Equity ratio is a key financial ratio that helps us analyse if a business functions heavily on its own capital or borrowed funds. 

In this article, let’s break down the meaning, formula, and importance of equity ratio, and how you can use it to make smarter investment decisions. 

Here’s all you need to know to use it like a pro.

What is Equity Ratio?

Equity ratio measures the share of a company’s assets that are funded by shareholders’ equity. Simply put, it’s a number that shows how much of the business is actually ‘owned’ by its shareholders versus what’s funded by loans.

A company with a high equity ratio is generally considered to be less risky for investors and lenders. On the other hand, a low equity ratio tells us that the business uses a lot of borrowed money, which can mean higher solvency risk. However, it is important to consider asset quality as well. High equity backing weak or illiquid assets (e.g., goodwill, intangibles, revaluations) isn’t the same as equity backing productive assets.

Equity Ratio Formula: How to Calculate Equity Ratio?

The formula behind equity ratio is simple and straightforward. Here’s the formula: 

Equity Ratio = Total Equity/Total Assets

Where, 

• Total Equity: This is the shareholders’ funds or a business’s net worth shown in the balance sheet.
• Total Assets: This sum includes both current and non-current assets, everything the company essentially owns.

You can multiply the answer by 100 if you want the result as a percentage. 

Let’s understand this with an example. Suppose a company has total assets of ₹50 crore and total equity of ₹22 crore. Then, the company’s equity ratio will be: 

Equity Ratio = 22/50 = 0.44 or 44%

This means 44% of the company’s assets are funded by equity and the rest by total liabilities.

Why Does Equity Ratio Matter?

Equity ratio reveals a company’s financial strength at a glance. Here’s why it’s so important for investors:

• Judges Financial Health: High equity ratios signal low debt and more self-reliance.
• Spots Risk: Low ratios suggest a company relies heavily on borrowed money, making it riskier in tough times.
• Lender’s Perspective: Banks and lenders prefer companies with high equity ratios; these companies can get credit more easily and on better terms.
• Investor Confidence: Investors feel safer with a company that can fund itself.

How to Interpret Equity Ratio

Understanding what counts as ‘good’ or ‘bad’ isn’t one-size-fits-all. It is important to understand the context before making any decisions: 

Good Equity Ratio

• Above 50%: Usually considered strong and conservative, showing the company funds most assets from its equity.
• 50-80%: Companies with a 50-80% equity ratio are considered financially stable and conservative as they rely more on shareholder equity for funding. 
• 20-40%: This range usually suggests that a business is more reliant on debt. A company with higher leverage comes with higher insolvency risks. 

Note: A lower equity ratio is not always bad in case of a growth-oriented company. Companies use debt as a growth strategy for expansion and generating higher returns. 

You should also remember that different industries have different norms. For example, capital-intensive sectors like utilities and manufacturing, often have lower equity ratios; while asset-light sectors or service-providing businesses usually have high equity ratios. So, make sure that you compare companies within the same sectors.  

High Equity Ratio

A high equity ratio demonstrates “credit worthiness,” the business could survive a downturn more easily, raise funds by issuing new equity, and often enjoys lower borrowing costs.

Low Equity Ratio

A low equity ratio signals possible trouble ahead if revenues fall or debt costs rise. It means the company depends more on creditors, which can lead to solvency issues if cash flows dry up.

You shouldn’t rely solely on equity ratio to make your investment decisions. Make sure that you also analyse other financial metrics like debt-to-equity ratio, ROE, ROA, and others. Doing so will ensure that you make well-informed investment choices.

Equity Ratio Vs Debt-to-Equity Ratio

It’s easy to get confused between equity ratio vs. debt-to-equity ratio, so here’s a quick comparison:

When Should Investors Use Each?

• Equity Ratio: You should use equity ratio when evaluating how much of a company is paid for with owners’ money and how safe the business might be from financial distress. It’s best for judging basic financial strength of a company.
• Debt-to-Equity Ratio: Use this to assess how much risk the business is taking by borrowing to invest or expand. It helps weigh the returns vs risks for companies taking on extra debt for growth.

Both ratios are most meaningful when you use them to compare different companies in the same industry or historical averages for the same company. They paint a fuller picture together, helping investors balance potential returns with safety.

Conclusion

Equity ratio is for investors who want to go beyond the basics and really understand a company’s financial DNA. It’s not just about how much the business earns, but also about how it funds its operations and weathers bad times. Knowing how to check, calculate, and interpret this number will help you make smarter, safer investment choices every time. 

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