What Is the Shareholder Equity Ratio?
Let me tell you about the shareholder equity ratio. It measures how much of a company's assets come from issuing equity shares instead of taking on debt. If the ratio is low, that means the company has used more debt to fund its assets. It also gives you an idea of what shareholders might get if the company has to liquidate.
You calculate this ratio as a percentage by dividing total shareholders' equity by the total assets of the company. This result shows the portion of assets that shareholders have a claim on. All the numbers come from the company's balance sheet.
Key Takeaways
- The shareholder equity ratio reveals the portion of a company's assets that comes from investor ownership rather than loans or other forms of debt.
- 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.
Formula for the Shareholder Equity Ratio
The formula is straightforward: Shareholder Equity Ratio = Total Shareholder Equity / Total Assets. You get total shareholders' equity from the balance sheet, based on the accounting equation: SE = A - L, where SE is shareholders' equity, A is assets, and L is liabilities.
What Does the Shareholder Equity Ratio Tell You?
If a company sold all its assets for cash and paid off all liabilities, the remaining cash would be the firm's equity. Shareholders' equity includes common stock value, additional paid-in capital, and retained earnings—that's the true value of the business.
A 100% ratio means all assets are funded with equity, not debt. This could be because strong earnings are paying down debt and building equity. Some argue high equity has downsides, like missing out on debt benefits such as lower costs or less dilution. But it's a good position; the company can choose to take on debt later for growth.
Remember, this ratio is most useful when compared to peers in the same sector. Each industry has its own normal level of shareholders' equity to assets.
Example of the Shareholder Equity Ratio
Suppose you're looking at investing in ABC Widgets, Inc., and you want to check its financial strength and debt. Calculate the shareholder equity ratio using balance sheet numbers. For year-end, you might use return on equity (ROE) or return on average equity (ROAE) for a profitability snapshot.
From the balance sheet: total assets $3.0 million, total liabilities $750,000, total shareholders' equity $2.25 million. So, ratio = $2,250,000 / $3,000,000 = 0.75, or 75%. This means 75% of assets are financed by equity, and only 25% by debt.
In a liquidation, shareholders would keep 75% of the resources after debt payoff.
When a Company Liquidates
If a business liquidates, it sells all assets, and creditors and shareholders claim what's left. Secured creditors come first since their debts are backed by collateral. Then other creditors like suppliers, bondholders, and preferred shareholders get paid before common shareholders.
A low debt level means shareholders are more likely to get some repayment. But often, assets run out before shareholders see anything.
