Day 5 of Fundamental Investing
Continuing with the solvency ratios, the second solvency ratio is the Equity Ratio!
What is it?
The equity ratio is the investment leverage or solvency ratio that measures the number of assets that are financed by owners’ investments by comparing the total equity in the company to the total assets. The equity ratio highlights two important financial concepts of a solvent and sustainable business. The first component shows how much of the total company assets are owned outright by the investors. In other words, after all of the liabilities are paid off, the investors will end up with the remaining assets. The equity ratio measures how much of a firm’s assets were financed by investors. In other words, this is the investors’ stake in the company. This is what they are on the hook for. The inverse of this calculation shows the number of assets that were financed by debt. Companies with higher equity ratios show new investors and creditors that investors believe in the company and are willing to finance it with their investments.
How to calculate it?
Here's an image for the same:
What's its significance?
In general, higher equity ratios are typically favourable for companies. This is usually the case for several reasons. Higher investment levels by shareholders show potential shareholders that the company is worth investing in since so many investors are willing to finance the company. A higher ratio also shows potential creditors that the company is more sustainable and less risky to lend future loans.
Equity financing in general is much cheaper than debt financing because of the interest expenses related to debt financing. Companies with higher equity ratios should have less financing and debt service costs than companies with lower ratios. As with all ratios, they are contingent on the industry. Exact ratio performance depends on industry standards and benchmarks.
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