Proprietary ratio | Equity ratio
/What is the Proprietary Ratio?
The proprietary ratio is the proportion of shareholders' equity to total assets, and as such provides a rough estimate of the amount of capitalization currently used to support a business.
How to Calculate the Proprietary Ratio
To calculate the proprietary ratio, divide total shareholders' equity by total assets. The results will be more representative of the company's true situation if you exclude goodwill and intangible assets. from the denominator. The more restrictive version of the formula is as follows:
Shareholders' equity ÷ Total tangible assets = Proprietary ratio
How to Interpret the Proprietary Ratio
If the proprietary ratio is high, this indicates that a company has a sufficient amount of equity to support the functions of the business, and probably has room in its financial structure to take on additional debt, if necessary. Conversely, a low ratio indicates that a business may be making use of too much debt or trade payables, rather than equity, to support operations (which may place the company at risk of bankruptcy). In the latter case, a business may need to acquire a significant equity investment in order to remedy the perceived risk level caused by the existence of too much debt on its balance sheet.
Thus, the equity ratio is a general indicator of financial stability. It should be used in conjunction with the net profit ratio and an examination of the statement of cash flows to gain a better overview of the financial circumstances of a business. These additional measures reveal the ability of a business to earn a profit and generate cash flows, respectively.
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Example of the Proprietary Ratio
ABC Company has shareholders' equity of $2,000,000 and total assets of $5,000,000. There is no goodwill on its balance sheet, nor any intangible assets. Its proprietary ratio is:
$2,000,000 Shareholders' equity ÷ $5,000,000 Total tangible assets
= 40% Proprietary ratio
Thus, shareholders have contributed 40% of all funds used in the business, with creditors contributing the remaining 60% of funds. This ratio can be monitored on a trend line or compared with the same metric for competitors to gain a better understanding of the outcome.
Problems with the Proprietary Ratio
The proprietary ratio is not a clear indicator of whether or not a business is properly capitalized. For example, an excessively high ratio can mean that management has not taken advantage of any debt financing, so the company is using nothing but expensive equity to fund its operations. Instead, there is a balance between too high and too low a ratio, which is not easy to discern.
Also, the ratio is not necessarily a good indicator of long-term solvency, since it does not make use of any information on the income statement, which would indicate profitability or cash flows.
Terms Similar to the Proprietary Ratio
The proprietary ratio is also known as the equity ratio or the net worth to total assets ratio.