Every company needs a share of equity in order to survive economically. The equity serves as a reserve for unforeseen expenses, a solid share of equity also has a positive effect on the granting of credits and loans. The share of equity in the total capital of a company is expressed in the form of the equity ratio .
Definition: what is the equity ratio?
The equity ratio expresses the share of equity in the total capital of a company and is usually given in percent. The equity component is calculated by dividing the equity by the total capital available in the company. Based on the equity ratio, it is possible to draw conclusions about the creditworthiness and risk of a company. A high equity ratio implies a low level of debt and thus a lower risk of bankruptcy for the company. In other words, the higher a company’s share of its own capital, the lower the risk of over-indebtedness and insolvency. However, a high equity ratio reduces the return on equity . She can get through
- Capital release
- Capital increase
- Retention of profits
The equity ratio as an important parameter in a company
The equity ratio is an important parameter in a company, it is an important balance sheet figure and thus provides information about the capital structure of a company. In the company, this balance sheet ratio is an important basis for financial decisions. The equity ratio is also of interest to banks, rating agencies, competitors, shareholders and creditors. All these interest groups can read the economic performance of a company from the balance sheet.
The creditworthiness of a company can be assessed using the equity ratio and other financial ratios. The ratio puts equity and total capital in relation. The equity is available as a liability pool for the creditors, so the share of equity in the total capital plays an important role when it comes to granting credits, loans or subsidies. After all, if the worst comes to the worst, only the company’s own capital can be accessed. In the event of bankruptcy, outside capital is taboo. In the balance sheet, the equity ratio represents the percentage ratio between equity and total assets.
The equity ratio – an expression of financial stability
The equity ratio expresses the financial stability and independence of a company; the higher the ratio between equity and borrowed funds, the more independent and stable a company is. If there is a higher risk of return, the equity ratio should be higher. In this way, a company can access reserves in the form of equity capital in difficult economic times. Taking into account the security aspect, the equity ratio should be optimized so that a company is largely independent of creditors. A favorable EK / GK ratio improves the negotiating position with banks for follow-up financing and better absorbs possible future losses. The burden on a company with interest and principal payments is reduced. Because no real interest has to be paid for EK,
Criteria for the equity ratio
The average amount of equity depends on the industry. In the case of credit institutions, the equity ratio is only low in comparison, it is around 10 percent. In the case of investment-intensive companies in the manufacturing sector, the equity ratio is very high on average. It also depends on the size of a company; the ratio of equity to total capital tends to be higher in large companies than in small companies. Studies have shown that the smaller the company, the lower the equity ratio.
The legal form of a company also has an impact on the equity ratio; in partnerships, the equity portion is traditionally significantly lower than in corporations. The reason for this is that in partnerships at least one partner must be fully liable with all of their private assets. Corporations often belong to investment and capital-intensive industries and usually have high equity ratios.
Positive effects of the equity ratio
A solid equity ratio leads to lower interest rates when borrowing and, associated with this, to lower interest expense and repayment payments. A good equity ratio also leads to favorable debt ratios, which include the debt service coverage ratio. An optimal equity / debt ratio stands for a lower level of indebtedness, it reduces the income and employment risks. The break-even point is lower, the company generates profits faster.
An increased equity to total capital ratio provides good protection for the damage caused by losses that may have to be compensated, so companies with high equity ratios are less susceptible to crises. The risk of default against creditors decreases with increasing equity ratio, companies with a high equity ratio are able to absorb losses over a longer period of time with equity and survive times of crisis unscathed. The risk of falling into bankruptcy is significantly lower for these companies. The only positive effect that a low equity ratio has is the higher return on equity.