What is the shareholder-equity ratio?
The shareholder-equity ratio shows the percentage of a company’s assets earned by issuing equity shares instead of taking on debt. A corporation has used more debt to pay for its assets if the ratio result is lower. Additionally, it displays the potential payout to shareholders if the business must go into liquidation.
The shareholder-equity ratio is computed and represented as a percentage by dividing the entire shareholder-equity amount by the business’s total assets. The outcome shows how much of the assets shareholders still have a claim to. The corporate balance statement contains the numbers used to compute the ratio.
The Shareholder Equity Ratio Formula Is
Shareholder Equity Ratio=Total Assets/Total Shareholder Equity
SE=A−L
where:
- SE=Shareholders’ Equity
- A=AssetsL=Liabilities
What Information Does the Shareholder Equity Ratio Provide?
Any money left over after a corporation pays off all its debts and sells all its assets for cash is known as equity. The value of a company’s common stock plus extra paid-in capital plus retained profits equals its shareholders’ equity. The sum of these components represents a company’s actual worth.
A business has nearly entirely funded its assets with equity capital rather than debt when its shareholder-equity ratio is close to 100%. Comparing equity capital to debt finance, however, reveals some disadvantages. It usually costs more than debt and necessitates granting new shareholders voting rights and diluting ownership.
Comparing the shareholder equity ratio to peers or rivals in the same industry gives it the most tremendous significance. Every sector has a typical or standard ratio of shareholders’ equity to assets.
An illustration of a shareholder-equity ratio
Before investing, let’s say you want to know ABC Widgets, Inc.’s total debt status and financial condition. Finding the company’s equity ratio is the first step. The computation of return on equity (ROE) yields a year-end figure. Return on average equity is another tool to gain a quick sense of profitability (ROAE).
According to the balance statement, the firm has $3.0 million in total assets, $750,000 in total liabilities, and $2.25 million in total shareholders’ equity. Enter the ratio’s calculation here:
Equity held by shareholders = $2,250,000 / 3,000,000 =.75, or 75%
This shows that shareholder equity is the remaining 75% of ABC Widgets’ assets, with debt accounting for just 25%.
Put another way, the shareholders would still own 75% of ABC Widgets’ financial resources even if it had to sell all its assets to settle its debt.
When a Business Dissolves
If a corporation decides to liquidate, all its assets are sold, and shareholders and creditors have rights over them. Secured creditors are given precedence because their debts were secured by assets that may now be liquidated to pay them back.
Other creditors, suppliers, bondholders, and preferred shareholders get payment before ordinary shareholders.
A low debt load increases the likelihood that stockholders may be partially paid back after a liquidation. Nonetheless, there have been several instances when the funds were depleted before any stockholder’s payout.
Conclusion
- The shareholder-equity ratio shows the percentage of a company’s assets supported by stock issuance instead of borrowing.
- A company has funded more assets using stock than debt if its ratio result is closer to 100%.
- The ratio is a predictor of the potential long-term financial stability of the firm.
