Equity Ratios explained
The equity ratio serves as a key indicator of a company's use of leverage by analysing the relationship between its total assets and shareholder equity.
It offers insight into the company's approach to managing its debts while financing its assets, thus providing a snapshot of its overall financial stability which is useful for investors seeking to understand the potential risk of investing in a company, for example where the company is a Special Purpose Vehicles created for the purpose of a real estate development.
Equity ratio is typically expressed as a percentage, calculated by dividing total shareholders' equity by the total assets of the company. The 3 common ways Equity ratios are presented are by:
- Percentage: For example as 50% Equity Ratio means that the balance sheet contains half equity and half debt.
- Monetary: For example, as '1.5' which means for every £1 of debt on the balance sheet there is £1.50 of equity.
- Decimal: For example, '0.50' where 1.00 is the whole this would represent that equity was half of the balance sheet.
Equity Ratio = Shareholder's Equity / Total Asset
It appears as shareholders' equity in the liabilities on company's balance sheet a.
Companies with a lower equity ratio typically have used more debt financing secure on the company's assets to fund asset acquisition or operations, which may suggest a higher level of financial risk. Conversely, a higher equity ratio is generally seen as positive, reflecting a company's ability to finance its assets more through equity than debt, thereby indicating efficient financial management. This ratio, derived from dividing Total Equity by Total Assets, serves as a barometer for measuring how much a company relies on debt versus equity in its asset financing.
A ratio of .50 or lower is indicative of a company that is more leveraged, meaning it depends more heavily on debt for its financial operations. Ratios above .50, however, are indicative of a more conservative financial strategy, favouring equity over debt.
Take for instance Property Development Company 'Jones Developments', which possesses a development site with land (its total assets) valued at £5,000,000 and shareholder equity amounting to £2,000,000. When we apply the equity ratio formula, we find a ratio that suggests a company navigating its financial structure with a modest tilt towards debt over equity at .40 which is 40% of equity remaining after debt is considered.
An equity ratio at or below .50 categorises a company as more leveraged, highlighting a greater reliance on debt in its financial structure.
A special purpose, also known as (SPV) or a special purpose entity (SPE), is a subsidiary created by a parent company to ring-fence any assets and operations contained within the SPV. The 2 key advantages of doing this is to:
- Isolate all financial risks from the activities of the SPV.
- Raise debt and equity financing based on the SPVs, and not parent company's balance sheet.
Importantly, this enables investors to be able to clearly understand the SPVs Equity Ratio.
An SPV is often used in Property Development schemes because:
- Property development can contain large risks.
- Property developers require project financing.