Shareholder Equity Ratio: Definition and Formula for Calculation (2024)

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 shareholder equity ratio is expressed as a percentage and 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.

Key Takeaways

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.

Shareholder Equity Ratio: Definition and Formula for Calculation (1)

The Formula for the Shareholder Equity Ratio Is

$\text{Shareholder Equity Ratio} = \dfrac{\text{Total Shareholder Equity}}{\text{Total Assets}}$ ShareholderEquityRatio=TotalAssetsTotalShareholderEquity

Total shareholders' equity comes from the balance sheet, following the accounting equation:

What Does theShareholder Equity RatioTell You?

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 its common stock value, 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 that the company has financed almost all of its assets with equity capital instead of taking on debt. Equity capital, however, has some drawbacks in comparison with debt financing. It tends to be more expensive than debt, and it requires some dilution of ownership and giving voting rights to new shareholders.

The shareholder equity ratio is most meaningful in comparison with the company's peers or competitors in the same sector. Each industry has its own standard or normal level of shareholders' equity to assets.

Example of the 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. A year-end number is arrived at by using return on equity (ROE) calculation. You can use also get a snapshot idea of profitability using return on average equity (ROAE).

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.

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.

As a financial expert with a deep understanding of corporate finance and accounting principles, I can confidently delve into the topic of the Shareholder Equity Ratio and provide comprehensive insights into its significance, calculation, and implications for investors and stakeholders.

The Shareholder Equity Ratio serves as a crucial metric in assessing a company's financial structure and risk profile. This ratio essentially reveals the proportion of a company's assets that have been financed through the issuance of equity shares rather than through debt. The lower the ratio, the more a company relies on debt to fund its assets.

Calculation of Shareholder Equity Ratio: The formula for the Shareholder Equity Ratio is expressed as a percentage and is calculated by dividing the total shareholders' equity by the total assets of the company:

[ \text{Shareholder Equity Ratio} = \frac{\text{Total Shareholder Equity}}{\text{Total Assets}} ]

Total shareholders' equity is derived from the balance sheet using the accounting equation:

[ \text{SE} = \text{A} - \text{L} ]

Where:

( \text{SE} ) is Shareholders' Equity
( \text{A} ) is Assets
( \text{L} ) is Liabilities

Interpretation of Shareholder Equity Ratio: A Shareholder Equity Ratio approaching 100% indicates that a company has financed a significant portion of its assets through equity capital rather than debt. This implies financial stability in the long run, as shareholders have a substantial claim on the company's assets.

However, it's essential to note that high reliance on equity capital has its drawbacks. Equity financing tends to be more expensive than debt, and it often leads to dilution of ownership and granting voting rights to new shareholders.

Significance of the Ratio: The ratio is a key indicator of a company's financial health and stability. It is particularly meaningful when compared to industry peers, as each industry has its own standard or normal level of shareholders' equity to assets. Deviations from this norm can signal financial strength or weakness.

Example Illustration: Consider the scenario of ABC Widgets, Inc. with total assets of $3.0 million, total liabilities of $750,000, and total shareholders' equity of $2.25 million. The calculation of the Shareholder Equity Ratio is as follows:

[ \text{Shareholders' Equity Ratio} = \frac{\$2,250,000}{\$3,000,000} = 0.75 \text{ or 75%} ]

This means that ABC Widgets has financed 75% of its assets with shareholder equity, indicating that only 25% is funded by debt. In the event of liquidation, shareholders would retain 75% of the company's financial resources.

Liquidation Scenario: In the unfortunate event of liquidation, the Shareholder Equity Ratio becomes crucial. A low level of debt means that shareholders are more likely to receive repayment during liquidation. However, it's important to note that secured creditors have the first claim on assets, and shareholders may not receive full repayment if the company's assets are exhausted.

In summary, the Shareholder Equity Ratio provides valuable insights into a company's financial structure, risk exposure, and potential outcomes in scenarios such as liquidation. It is a vital tool for investors and stakeholders seeking to evaluate the financial health and stability of a company.