What Is the Shareholder Equity Ratio?
The shareholder equity ratio indicates how much of a company's 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 ratio, expressed as a percentage, is 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 company's assets are funded by issuing stock rather than borrowing money.
- The closer a firm's 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.
Understanding Shareholder Equity Ratio
The Formula for the Shareholder Equity Ratio Is
Shareholder Equity Ratio=Total AssetsTotal Shareholder Equity
What is the Shareholder Equity Ratio?
What Does the Shareholder Equity Ratio Tell You?
The balance sheet displays the following accounting equation:
If a company sold all of its assets for cash and paid off all of its liabilities, any remaining cash equals the firm's equity. A company's shareholders' equity is the sum of common stock, additional paid-in capital, and retained earnings. The sum of these parts is considered to be the true value of a business.
Shareholder equity ratio is most meaningful in comparison with the company's peers. Each industry has its own normal level.
When a company's shareholder equity ratio approaches 100%, it means the company has financed almost all of its assets with equity instead of taking on debt.
Calculating the ratio for a company is more meaningful if you compare it with other companies in its industry. Each industry has its own standard or normal level of shareholders' equity to assets.
Example of Shareholder Equity Ratio
Say that you're 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 company's 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 company's 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.