The equity ratio measures the amount of leverage that a business employs. It does so by comparing the total investment in assets to the total amount of equity. If the outcome of the calculation is high, this implies that management has minimized the use of debt to fund its asset requirements, which represents a conservative way to run the entity. Conversely, a low ratio indicates that a large amount of debt was used to pay for the assets.
To calculate the equity ratio, divide total equity by total assets (both found on the balance sheet). The formula is:
Total equity ÷ Total assets
For example, ABC International has total equity of $500,000 and total assets of $750,000. This results in an equity ratio of 67%, and implies that 2/3 of the company's assets were paid for with equity.
A low equity ratio is not necessarily bad. It means that, if the business is profitable, the return on investment is quite high, since investors did not have to invest an inordinate amount of funds in comparison to the return generated. However, if the company's results become unprofitable, the interest expense associated with the debt could quickly eliminate all cash reserves and thrust the company into bankruptcy. This scenario is not necessarily the case when interest rates are low, since it requires little cash flow to pay for ongoing interest costs.
A low equity ratio is easier for a business to sustain in an industry where sales and profits have minimal volatility over time. Conversely, a highly competitive industry with constantly changing market shares may be a bad place in which to have a low equity ratio.
Potential investors and creditors prefer to see a high equity ratio, since it implies that a company is conservatively managed and always pays its bills on time.