Equity Ratio

The equity ratio is a metric used in the domain of finance and comes into play when evaluating a company’s performance. It is just one of the measures used to determine how much leverage a company uses. The measure considers the assets of a company and the amount of equity of a company to decide how it handles its debts and funds its requirements for assets. While assessing a company’s financial performance the equity ratio says a lot about the prospects of a company’s operations and growth.

Hence, it is an important metric to consider while thinking of investing in a company’s stock, either directly or via the mutual fund route. The following article delves into aspects of the equity ratio, giving you the knowledge to make informed investment decisions.

What is the equity ratio?

The equity ratio is a financial metric that measures a company's leverage by comparing its equity to its total assets. This ratio indicates the extent to which a company funds its assets with equity as opposed to debt. If you're a shareholder or prospective investor, understanding the equity ratio is essential for assessing a company's financial stability and risk profile within its industry.

In essence, a low equity ratio suggests that a company relies heavily on debt to finance its assets, which can imply a higher financial risk. In contrast, a high equity ratio demonstrates that the company funds its asset requirements primarily through equity, maintaining lower debt levels. This is often viewed as a sign of financial strength and stability.

For instance, if you’re investing through the Bajaj Finserv Mutual Fund Platform, comparing equity ratios of companies within funds allows you to gauge each company’s financial position. This insight can aid in selecting investments aligned with your risk tolerance and growth expectations.

Formula of equity ratio

The equity ratio formula is a valuable tool for assessing a company’s operational success, particularly if you’re considering an investment in its stock—whether directly or through mutual fund schemes. By calculating the ratio of a company's total equity to its total assets, the equity ratio reveals how much of the company’s assets are funded by shareholders' equity versus debt. This insight helps investors understand the company’s financial stability and risk level.

A higher equity ratio generally signals financial health, as it indicates the company uses more equity and less debt to support its operations. This reduces financial risk, making it an attractive choice for conservative investors. Conversely, a low equity ratio suggests a heavier reliance on debt, which may pose higher risk during economic downturns or periods of financial instability.

For mutual fund investors, analysing the equity ratios of companies within a fund can provide a clearer view of each company’s financial footing. On platforms like Bajaj Finserv Mutual Fund, this metric enables investors to make informed decisions by comparing companies’ capital structures and risk levels across different funds

Using the formula, the equity ratio equals the total equity divided by the company’s total assets. The mathematical formula to calculate the equity ratio is expressed as:

It is important to note that the company’s assets (as shown in the formula) include current and non-current assets) and the total equity comprises the total shareholder equity. The resultant ratio generated from the calculation is expressed as a percentage. Therefore, the result from the above calculation must be multiplied by 100 to get the final percentage.

How to calculate equity ratio

This ratio isn't typically provided by online calculators, so manually computing it
can deepen your understanding of fund investments.

Example of equity ratio calculation

An example of the equity ratio calculation will help you to understand the concept of equity ratio better and know how to apply the formula:
Suppose a company called Company Infinity has total assets of the value of Rs. 50 crore. The company’s total equity is valued at Rs. 22 crore. Using the formula to find the equity ratio:

The resultant figure above portrays that the Company Infinity has leveraged its debts. The company has more debt (Rs. 28 crore) than equity generated by its shareholders.

Also read: What is financial ratio analysis

Importance of an equity ratio value

The equity ratio is a value that tells you about a company’s leveraging capacity in terms of how it funds its operations and other financial requirements. Any company that has an equity ratio equal to .50 or less, is considered to be a company that is leveraged. The higher the resultant equity ratio or figure, the less leveraged the company is said to be. In contrast, the equity ratio of a company that is .50 or more shows that the company is a conservative one as it generates more funding from its shareholder equity than from any source of debt. If you are an investor, you would likely select a company that has a conservative perspective as this would be a less risky option for investment. Such a company is savvy at raising funds for asset requirements without sustaining debt.

Furthermore, lending firms are more likely to extend loans and other forms of credit to conservative companies than to companies with a low equity ratio. The higher the equity ratio, the more indication present that a company is managing itself in a financially sound manner. This translates to the company being able to settle its debts on time and in full.

What is a good equity ratio?

After you have grasped the equity ratio meaning and how it can help you make an informed decision about investing in a specific company’s stock, your investment process becomes hassle-free. However, you may be wondering what constitutes a “good” equity ratio. The equity ratio is industry-specific and what comprises a favourable ratio depends on the industry to which a particular company belongs. What’s more, the equity ratio depends on the company’s fundamental financial health.

Nonetheless, a general rule of thumb states that most companies prefer to have an equity ratio in the range of close to 50%. Companies whose equity ratios equal 50%-80% fall within the “conservative” category and show financial stability. Companies with equity ratios ranging from 20%-40% tend to be classified as “leveraged” and their financial health is open to question.

Also read: What is operational risk

Interpretation of equity ratio

By now, you must have a considerable degree of clarity on the equity ratio and what comprises a high ratio and a low ratio. However, this subject requires a little more in-depth analysis:

High equity ratio

A high equity ratio is considered anywhere between the range of 50%-80%. A high equity ratio indicates that the company has little or no credit risk, relying less heavily on loans.

Low equity ratio

A low equity ratio of a company is indicative of the company’s reliance on creditors. In the event equity interests are much lower than the percentage of debt, the company may be thought to be at risk for insolvency.

How to improve equity ratio

Equity ratio meaning is important for you to learn about a company’s financial strength, but it is not the only metric to consider. While there are more fundamentals of a company to consider when you are investing in it, either via direct equity investment or mutual funds, the equity ratio is a significant way to assess a company. Nonetheless, you should know that companies with an equity ratio on the low side can employ ways to raise the equity ratio over time. How do companies improve their equity ratios?

Companies may start on the path to enhancing their equity ratios by retaining their earnings instead of distributing them to shareholders. In this way, the equity base of a company rises and so does its overall equity ratio. Many companies retain earnings and profits by reinvesting in the company’s operations and expanding the business.

Another method by which companies may boost their equity ratio is by issuing fresh equity. New equity issued to shareholders allows a company to raise capital and this can increase its equity base, and in turn, its equity ratio. Finally, for a company to effectively raise its equity ratio, it must find ways to rely less on credit. Reducing debt is a key way for companies to remain solvent with a considerable equity ratio.
Also read: What is plowback ratio

Key takeaways

• The equity ratio is calculated by dividing a company's total equity by its total assets, and multiplying by 100 to express it as a percentage if needed.
• A high equity ratio indicates financial stability with minimal debt, while a low ratio suggests reliance on debt, indicating higher financial risk.
• Understanding the equity ratio helps assess a company's operational success and is useful when investing in stocks or mutual fund schemes.
• To calculate the equity ratio, you need to find the company’s equity and total assets from its balance sheet and then apply the formula.
• While mutual fund calculators help estimate returns, they do not typically calculate the equity ratios of companies within a fund, so manual calculation is necessary for detailed analysis.

Conclusion

Financial planning through investment is a key way to grow your wealth and aim at capital appreciation. Knowing about your investments and aspects like metrics that can help you determine which investments may be appropriate for you is considered a sound way to begin your investment journey. The equity ratio is just one of the measures of evaluating a company’s financial health and can tell you about its dependability on credit versus its equity. While this is not the only quantifier to rely on for information about a company’s financials, it tends to give you a reliable indication.

Whether you are already an established investor or are just starting with baby steps, if you have chosen to invest in stock-related instruments like direct equity or mutual funds, there is nothing like researching before you invest. While you are choosing company stock to invest in or mutual funds that invest in a basket of company stock, it is vital to learn about a company’s performance, both financial and business-related. On the Bajaj Finserv Mutual Fund Platform, you get more than 1000 mutual fund schemes to choose from, according to your financial goals and risk profile. You also get resources to help you understand investments better and make informed decisions regarding your investments.

Essential tools for all mutual fund investors