What Is the Shareholder Equity Ratio?
The shareholder equity ratio indicates how much of a companys assets have been generated by issuing equity shares rather than by taking on debt. The lower the ratio result, the more debt a company has used to pay for its assets. It also shows how much shareholders might receive in the event that the company is forced into liquidation.
The shareholder equity ratio is expressed as a percentage and calculated by dividing total shareholders equity by the total assets of the company. The result represents the amount of the assets on which shareholders have a residual claim. The figures used to calculate the ratio are recorded on the company balance sheet.
- The shareholder equity ratio shows how much of a companys assets are funded by issuing stock rather than borrowing money.
- The closer a firms ratio result is to 100%, the more assets it has financed with stock rather than debt.
- The ratio is an indicator of how financially stable the company may be in the long run.
What is the Shareholder Equity Ratio?
The Formula for the Shareholder Equity Ratio Is
Shareholder Equity Ratio=Total AssetsTotal Shareholder Equity
Total shareholders equity comes from the balance sheet, following the accounting equation:
What Does the Shareholder Equity Ratio Tell You?
If a company sold all of its assets for cash and paid off all of its liabilities, any remaining cash equals the firms equity. A companys shareholders equity is the sum of its common stock value, additional paid-in capital, and retained earnings. The sum of these parts is considered to be the true value of a business.
When a companys shareholder equity ratio approaches 100%, it means that the company has financed almost all of its assets with equity capital instead of taking on debt. Equity capital, however, has some drawbacks in comparison with debt financing. It tends to be more expensive than debt, and it requires some dilution of ownership and giving voting rights to new shareholders.
The shareholder equity ratio is most meaningful in comparison with the companys peers or competitors in the same sector. Each industry has its own standard or normal level of shareholders equity to assets.
Example of the Shareholder Equity Ratio
Say that youre considering investing in ABC Widgets, Inc. and want to understand its financial strength and overall debt situation. You start by calculating its shareholder equity ratio.
From the companys balance sheet, you see that it has total assets of $3.0 million, total liabilities of $750,000, and total shareholders equity of $2.25 million. Calculate the ratio as follows:
Shareholders equity ratio = $2,250,000 / 3,000,000 = .75, or 75%
This tells you that ABC Widgets has financed 75% of its assets with shareholder equity, meaning that only 25% is funded by debt.
In other words, if ABC Widgets liquidated all of its assets to pay off its debt, the shareholders would retain 75% of the companys financial resources.
When a Company Liquidates
If a business chooses to liquidate, all of the company assets are sold and its creditors and shareholders have claims on its assets. Secured creditors have the first priority because their debts were collateralized with assets that can now be sold in order to repay them.
Other creditors, including suppliers, bondholders, and preferred shareholders, are repaid before common shareholders.
A low level of debt means that shareholders are more likely to receive some repayment during a liquidation. However, there have been many cases in which the assets were exhausted before shareholders got a penny.
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