Before discussing Equity ratio lets first see two terms called equity and debt.
• Equity means the share of ownership that one holds in some asset that can be a property or a business.
• Debt is what is owed by a person for any funds that are borrowed by him.Debt are generally in the form of a loan.
Now coming to Equity ratio, It is a financial ratio that gives the relative proportion of stockholder's equity that is used to finance an asset(s) .
We can represent equity ratio mathematically as, Owners Equity/Total Assets
The value for these 2 components is usually taken from the company's balance sheet. If the firm's equity are publicly traded the market value for these components are taken to calculate the equity ratio.
This ratio is an indicator of the level of leverage (The term leverage is a technique of multiply gains and losses. Leverages can be attained by buying fixed assets, borrowing money and using derivatives ) used by a firm. Equity ratio gives the proportion of the total assets of an organization or firm that are financed by stockholders and not the creditors.
For example, The Equity Ratio of a firm is equal to 8% ($ 79,180,000/$ 647,483,000).
A low equity ratio is beneficial for the stockholders if the company earns more rates of returns on assets than the interest rate paid to the creditors.
Equity ratio is a very common financial ratio in Europe where as in United States the Debt to Equity Ratio is used more often. The Debt-to-Equity ratio (D/E) is another financial ratio that indicates the relative proportion of owner's equity and debt that has been used to finance the assets of a company.
The D/E ratio is calculated using the formula, Debt (liabilities)/Equity.
This D/E ratio is closely related to leveraging. It is also called Risk, Gearing or Leverage. Like the Equity ratio the two components in debt-to-equity ratio are also taken from the firm's statement of financial position. If the firm's debt and equity are publicly traded the market value for these components are taken to calculate the ratio.
On a balance sheet, assets are equal to the debt or liabilities plus the equity.
A = D + E
E = A – D or D = A – E.
Thus the Debt to equity ratio is equal to:
D/E = D / (A – D)
Or D/E = (A – E) / E.
Both the formulas above are therefore same.
An example for the D/E ratio is as follows:
D/E ratio = USD 186,522/ USD133, 522 = 1.40
The equity ratio is used to ascertain the financial stability of a firm. It is important to understand the current status of a company to operate. These ratios can tell about the current status of a company.
A company that has less completely owned assets, and debt that are equal to or more than the worth of the assets, would not be good with investment point of view. Whereas, a company with more of assets and comparatively low debt may be a very good investment.
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