What Is the Shareholder Equity Ratio?
The shareholder equity ratio shows how much of the company's assets are funded by equity shares. The lower the ratio result, the more debt a company has used to pay for its assets. It also shows how much shareholders would receive in the event of a company-wide liquidation.
The ratio, expressed as a percentage, is calculated by dividing total shareholders' equity by total assets of the firm, and it represents the amount of assets on which shareholders have a residual claim. The figures used to calculate the ratio are taken from the company balance sheet.
- The shareholder equity ratio shows how much of a company's assets are funded by shareholder equity.
- The closer a firm's ratio result is to 100%, the more assets it has financed with equity instead of taking on debt.
- The ratio reveals how much a company depends on debt and how financially stable it may be in the long run.
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 is laid out in the format of 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.
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 one company doesn't have as much meaning until you compare it with industry and competitor benchmarks since each industry has its own standard or normalized level of shareholders' equity to assets.
Example of How to Use the Shareholder Equity Ratio
Say that you're analyzing a company for potential investment and want to assess ABC Widgets, Inc. in terms of 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.
How a Company Liquidation Takes Place
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, based on the specific assets that serve as collateral for a debt.
Other creditors, such as bondholders, are next in line to claim assets, followed by the shareholders. Preferred shareholders have priority over common shareholders when a company chooses to liquidate. A larger asset balance means that shareholders are more likely to receive some assets during the liquidation. However, there are many cases in which shareholders do not receive any value, such as a bankruptcy situation when a company is forced into liquidation.