When you're evaluating a potential company as an investment, the balance sheet matters, but it can also get very complicated. A simple way to look at a company's debt obligations is to examine its equity-to-asset ratio, a measure that can tell you the extent of a company's leverage. Read on to learn more about this means of judging a company's financial fitness.
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Definition
What is the equity-to-asset ratio?
The equity-to-asset ratio is a measure of how much of a company's assets are owned by investors and how much of a company's assets are leveraged. This is a really important ratio because you don't want to be investing in a company that's doing a lot of heavy borrowing just to stay in business.
If a company is instead looking to investors to help pay the bills, then it's owned by its owners and not effectively by its debtors. If a bankruptcy were to occur, the debtors would be taking a big chunk of the assets of a highly leveraged company, but the investors would get some amount of their investment back in a company that was primarily investor-funded.
Some companies have higher or lower equity-to-asset ratios, depending on the industry, so be sure to compare the company that interests you to its competitors so you can tell if the company is on par with the rest of the market.
How to calculate it
How do you calculate the equity-to-asset ratio?
The equity-to-asset ratio is very easy to calculate. Since equity is the difference between the value of the company's assets and liabilities, you'll first need both of those pieces of information. You'll be looking for total assets and total liabilities, both current and non-current.
To figure the equity-to-asset ratio, simply divide the value of your equity by the value of your assets. Equity is calculated by subtracting the total liability from the total value of your assets. For example, if you have $5 million in assets and $1 million in liabilities, you have $4 million in equity.
In this case, the formula for equity-to-assets in this case would be $4 million divided by $5 million, or 80%.
That looks like this.
First, calculating equity:
Equity = Total assets - total liabilities
= $5 million - $1 million = $4 million
Then calculating equity-to-assets ratio:
Equity-to-assets ratio = (Total equity / Total assets) x 100
= ($4 million / $5 million) x 100 = 80%
How to interpret it
Interpreting the equity-to-asset ratio
So you have the number now, but the ratio by itself doesn't really mean anything. Just because shareholders own 80% of the company's equity doesn't necessarily mean that's good; it might be terrible if the other companies in the industry tend to have equity-to-asset ratios around 90%. This is where investing gets tricky -- there are lots of ratios like this where you have to calculate the number not only for your company, but also for other companies like it.
But what does that mean? This is a question I had when I was first trying to learn how to compare companies. Often, companies have very notable rivals, which makes it a lot easier. Think Coca-Cola (KO -0.46%) vs. PepsiCo (PEP -0.5%), for example. But in other cases, they don't. In these situations, you can only do your best and try to perform the same calculation across the industry as consistently as possible. Compare companies that do one thing very well with similar companies that also do the same thing very well, and compare those that do many things that line up with others doing the same.
It'll never be perfect because nothing about investing is that mechanical; otherwise, it wouldn't be so tricky to get it right every single time. But the better you understand the company you're looking at, as well as its competition, the better you can judge how well it's really performing.
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Why it matters
Why the equity-to-asset ratio matters to investors
As mentioned above, the equity-to-asset ratio of a company gives you a general idea of how much of the company is actually owned rather than leveraged. The less debt a company has, the better that generally is for its longer-term health. There are exceptions, of course, but it's usually better to have less debt than more debt.
When you know that your company has 80% of its assets free of debt, you also know that 20% are encumbered. This can help you better plan if the ship starts to sink. Stockholders are often among the last to be compensated during a bankruptcy sale since debtors are generally first in line and may consume a great deal of the remaining value of the company while satisfying debt. If you're in doubt, choosing companies with high equity-to-asset ratios means you're more likely to have some kind of return -- even during bankruptcy -- than you would from a company with a very low equity-to-asset ratio.
However, this has to be a calculation you perform while looking at other things, too. There are no financial ratios that exist inside a vacuum. A company is generally a mix of good and bad, and you have to decide if the good outweighs the bad after all kinds of numbers are examined, including the equity-to-asset ratio.
Kristi Waterworth has no position in any of the stocks mentioned. The Motley Fool recommends the following options: long January 2024 $47.50 calls on Coca-Cola. The Motley Fool has a disclosure policy.
FAQs
To figure the equity-to-asset ratio, simply divide the value of your equity by the value of your assets. Equity is calculated by subtracting the total liability from the total value of your assets. For example, if you have $5 million in assets and $1 million in liabilities, you have $4 million in equity.
What is a good equity to assets ratio? ›
There is no ideal asset/equity ratio value but it is valuable in comparing to similar businesses. A relatively high ratio (indicating lots of assets and very little equity) may indicate the company has taken on substantial debt merely to remain its business.
What is a reasonable Equity Ratio? ›
What is a good debt-to-equity ratio? Although it varies from industry to industry, a debt-to-equity ratio of around 2 or 2.5 is generally considered good. This ratio tells us that for every dollar invested in the company, about 66 cents come from debt, while the other 33 cents come from the company's equity.
What is a good return on Equity Ratio? ›
ROE is especially used for comparing the performance of companies in the same industry. As with return on capital, a ROE is a measure of management's ability to generate income from the equity available to it. ROEs of 15–20% are generally considered good.
What is a good debt to asset ratio? ›
In general, a ratio around 0.3 to 0.6 is where many investors will feel comfortable, though a company's specific situation may yield different results.
What is a healthy equity ratio? ›
Still, as a general rule of thumb, most companies aim for an equity ratio of around 50%. Companies with ratios ranging around 50% to 80% tend to be considered “conservative”, while those with ratios between 20% and 40% are considered “leveraged”.
What is a healthy current asset ratio? ›
As a general rule of thumb, a current ratio in the range of 1.5 to 3.0 is considered healthy. However, a current ratio <1.0 could be a sign of underlying liquidity problems, which increases the risk to the company (and lenders if applicable).
What is a healthy equity to asset ratio? ›
Typically, a ratio of 0.5 or higher is considered good, but again, this can vary depending on the specific circ*mstances. If a company has a high equity to asset ratio, it's usually a good thing.
What does an equity ratio of 1.5 mean? ›
A debt-to-equity ratio of 1.5 would indicate that the company in question has $1.50 of debt for every $1 of equity. To illustrate, suppose the company had assets of $2 million and liabilities of $1.2 million. Since equity is equal to assets minus liabilities, the company's equity would be $800,000.
Do you want a high or low equity ratio? ›
In general, a lower D/E ratio is preferred as it indicates less debt on a company's balance sheet. However, this will also vary depending on the stage of the company's growth and its industry sector.
Return on Average Equity (ROAE) extends the ratio of Return on Equity. Instead of the total equity at the end of the period, it takes an average of the opening and the closing balance of equity for some time. It is calculated as Net earnings divided by Average total equity.
How much equity is considered good? ›
While average ratios, as well as those considered “good” and “bad”, can vary substantially from sector to sector, a return on equity ratio of 15% to 20% is usually considered good.
What is a good ratio for return on assets? ›
What Is Considered a Good ROA? A ROA of over 5% is generally considered good and over 20% excellent.
What is the equity to assets ratio? ›
To figure the equity-to-asset ratio, simply divide the value of your equity by the value of your assets.
What is the ideal debt-to-equity ratio? ›
Generally, a good debt ratio is around 1 to 1.5. However, the ideal debt ratio will vary depending on the industry, as some industries use more debt financing than others. Capital-intensive industries like the financial and manufacturing industries often have higher ratios that can be greater than 2.
What is the rule of thumb for debt to asset ratio? ›
As a rule of thumb, investors and creditors often look for a company that has less than 0.5 of debt to asset ratio. However, to determine whether the ratio is high or low, they also need to consider what type of industry the company is categorized in.
Is 70 debt-to-equity ratio good? ›
Generally, a good ratio is 70% debt and 30% equity or 2.33:1, but this may vary depending on the type of property involved. Higher risk properties like hotels or restaurants may want a lower ratio while lower risk properties like grocery store anchored retail centers may be able to get away with a higher ratio.
What is considered a good amount of equity? ›
Being equity rich means having at least 50% equity in your home, or owning more than half your home's market value outright. That's a positive financial position to be in for a number of reasons. It means you can feel relatively safe and sheltered from the risk of going underwater on your mortgage, for example.
What is a good fixed asset to equity ratio? ›
A business with $10,000 worth of fixed assets but $15,000 worth of equity capital has a ratio of 0.66. Any time this ratio is 1 or higher, a company has a positive fixed-asset-to-equity-capital ratio.
What is a good asset quality ratio? ›
RATING THE ASSET QUALITY FACTOR
2 A rating of 2 indicates satisfactory asset quality and credit administration practices. The level and severity of classifications and other weaknesses warrant a limited level of supervisory attention.
