Equity Ratio

Equity Ratio

Sweat equity is the most valuable equity there is. Know your business and industry better than anyone else in the world. Love what you do or don’t do it. – Mark Cuban

What is the equity ratio?

Measures the use of equity to finance a company.

How is the equity ratio calculated?

Equity ratio = total equity / total assets.  Total equity is the balance remaining after liabilities have been deducted from total assets; total assets includes all assets owned by a business. 

What does the equity ratio mean to my business?  

The lower the equity ratio is the greater the reliance on debt to finance the business and the greater the financial risk.  The higher the ratio the opposite is true.  

Financial institutions are more likely to provide lending to a business with a higher equity ratio as it views the business as effectively managing its resources and able to repay its debts.   

A profitable business with a low equity ratio would be providing a high return on its equity.  Problems can occur when the equity ratio is low, and the business is not profitable.  The reliance on debt to finance an unprofitable business becomes an expensive proposition when interest expense becomes burdensome.

Negatives to the equity ratio:
By itself, the equity ratio expresses the percentage of the company or business that is financed by equity.  It falls short of evaluating the effective (or ineffective) use of equity, which is where the return on equity ratio comes in.