Asset To Equity Ratio Meaning Formula Calculation Example

Asset To Equity Ratio Meaning

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Companies use a combination of equity and debt to finance their operations or invest in assets. Therefore ratios like “asset to equity,” “equity to asset,” (equity ratio), and “debt to equity” are crucial. In addition, these ratios help understand the relationship between a firm’s total assets, shareholders’ equity, and debt.

Key Takeaways

Asset to Equity ratio is a financial ratio showing the relationship between a company’s total assets and its shareholders’ equity. It is a parameter to determine the leverage position of a company.Companies often try to have a lower value for this ratio; basically, less than two since a higher ratio is bad for business and company fundamentals.The ratio is employed in conjunction with the debt-to-equity ratio. It helps an investor understand an entity’s financial health before investing.It is rare but possible for a company to work on its internal aspects, pay off its debt with time, streamline its cash flows and contribute to reducing the ratio from high to low with time.

Asset To Equity Ratio Explained

The asset to equity ratio compares the total assets of a company to its shareholder’s equity. It may look easy to calculate, but it plays a vital role in determining a company’s financial leverage and stability. When this ratio of a company increases, it points out that it is under severe debt and is slowly losing its credibility to access additional debt financing.

Ideally, every company aims to keep this ratio as low as possible, as it plays a critical indicator for investors to understand the business’s financial health. It is often advised that investors study and comprehend business fundamentals and not just invest with a surface and incomplete knowledge about a company; therefore, many ratios and values depict a company’s actual and fair value.

A low ratio value signifies conservative financing with a more significant portion of investor funding and small debt. The ratio depends on the company’s industry, assets, and financial conditions. There is no ideal ratio value, but every company likes to keep it below the value of 2. Based on this parameter, the firm’s fundamentals are judged and compared with other companies.

Generally, a value higher than two indicates that the company has taken considerable debt to remain in business. Another way of contemplating the scenario would be a high value of this metric comparing asset and equity resembles that the return on borrowed capital exceeds the cost of that capital. Therefore, analyzing the financials and financial metrics like the asset to equity correlation is an essential parameter for banks while assessing the firm for credit and loan sanctions.

The asset to equity ratio interpretation parallels the debt to equity ratio (D/E) and equity ratio. A lower D/E ratio is generally favored since it shows less debt on a company’s financials. At the same time, a low equity ratio is considered a sign of higher risk since it indicates that the company predominantly borrowed money to buy its assets. Conversely, a higher equity ratio signifies efficiently funded asset requirements with little debt.

Investors and analysts give substantial importance to the ratio, especially when planning to make a long-term investment. It is possible that, at a glance, a company with a high ratio may look inviting based on some other factors and may also operate in the market for the long term. Yet, it is not wise to invest in such companies if an investor believes in value investing and does not share a good risk appetite. At the same time, a company can work on its internal issues and bring its total asset to equity ratio from a high value to a low value by paying off its debts and regulating its cash flows.

Formula

The asset to equity analysis establishes an equation between a firm’s total assets and shareholders’ equity. Hence the application of its formula is significant for many.

Formula:

Asset to equity ratio = Total assets/shareholders’ equity

Calculation Example

Maxine owns a battery company, has listed the company on the New York Stock Exchange, and is performing well in the market; Maxine is receiving orders from different states and many machine and equipment companies. Henry, an investor, is planning to invest by buying some of its stocks for the long term. He is smart, so he measures Maxine’s company with different parameters and calculates its asset to equity ratio.

So if the company has $9,000,000 of total assets and $8,000,000 shareholders’ equity, the ratio value equals 1.125, which is a good value from the business perspective. Therefore, Henry trusts Maxine’s company and buys its stocks as a long-term investment.

In contrast, if the company had total assets of $9,000,000 and shareholders’ equity of $2,250,000, the ratio would have come to be 4, which is very risky. Furthermore, an investor may derive and check other parameters to make the final decision.