Learn something new every day
More Info... by email
An equity ratio is a calculation or financial ratio that determines the amount of leverage a company has to use. In reality, it is typically referred to as a debt/equity or debt to equity ratio because it measures the amount of the company's liabilities compared to its stockholders' equity. Another way to look at the equity is to consider it as the proportion of debt the business is using to finance the assets of the business.
The equity ratio is calculated by dividing the total liabilities of the company by the total shareholders’ equity. Generally, this is the equation used for the calculation. A similar calculation only includes the long-term debt as part of the liabilities rather than total liabilities long- and short-term).
Typically, a debt to equity ratio refers to business financials. In other circumstances, however, it can also be applied to personal financial situations. In this case, the equation calculates the amount of personal debt that is financing the personal assets of the individual.
Since the equity ratio is a measurement, whether the measurement is high or low is an indication of the financial status of the company. For example, a high debt to equity ratio indicates that the company is financing its growth with a large amount of debt. Generally, the fallout of a company with a high equity ratio is that the earnings of the company fluctuate. Primarily, the fluctuation is because of the interest expense the company incurs from financing the debt.
A high equity ratio, however, does not automatically indicate that the earnings of the company are low. In fact, the opposite tends to be true. Companies that finance an increase in company operations with debt, for example, has the ability to generate a higher income than if it did not have the money to fund the various people and sources required to increase the operations.
When earnings for the business increase, this also tends to increase the earnings for the shareholders as well. This is because the earnings for the company increase, but the number of shareholders remain the same. This causes an increase of available funds to be spread and distributed among the same number of shareholders, thus increasing shareholder income.
The industry the company is involved in can also have an effect on the ratio. For example, auto manufacturers tend to have a high ratio. Computer companies, on the flip side, tend to have a low ratio.