What is equity ratio?

The equity ratio is a financial metric that measures the proportion of a company’s total assets financed by shareholders’ equity (i.e., the owners’ investment) rather than debt. It’s a key indicator of financial stability and leverage, showing how much of the company is "owned" versus "owed." A higher equity ratio typically suggests a stronger, less debt-reliant business, while a lower ratio indicates greater dependence on borrowed funds.

Here’s a detailed explanation based on standard financial principles as of now:

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Formula

Equity Ratio = Shareholders’ Equity ÷ Total Assets

• Shareholders’ Equity: The net worth of the company attributable to owners, calculated as Total Assets minus Total Liabilities (e.g., share capital, retained earnings).
• Total Assets: Everything the company owns (e.g., cash, inventory, property), funded by equity and liabilities combined.

The result is usually expressed as a percentage or decimal (e.g., 0.60 or 60%).

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Interpretation

• High Equity Ratio (e.g., 0.70 or 70%): Most assets are funded by equity, indicating low debt, financial independence, and stability. Attractive to conservative investors, but may suggest underutilized borrowing capacity for growth.
• Low Equity Ratio (e.g., 0.30 or 30%): More assets are financed by debt, signaling higher leverage and risk. It can boost returns in good times but strain finances if revenue dips.
• Industry Context: Norms vary—capital-intensive sectors (e.g., manufacturing) often have lower ratios (30-50%), while tech startups might aim higher (50-80%).

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Example Calculation

• Scenario: A company has:
  • Total Assets = ₹10,00,000 (e.g., cash, equipment, property).
  • Total Liabilities = ₹4,00,000 (e.g., loans, payables).
  • Shareholders’ Equity = Total Assets - Total Liabilities = ₹6,00,000.
• Equity Ratio:
  ₹6,00,000 ÷ ₹10,00,000 = 0.60 or 60%.
• Meaning: 60% of the company’s assets are funded by equity, and 40% by debt.

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Why It Matters

1. Risk Assessment: Lenders and investors use it to gauge solvency—higher equity means less chance of default.
2. Creditworthiness: Banks prefer a decent equity ratio (e.g., 40%+) when approving loans, as it shows "skin in the game."
3. Growth Strategy: Low ratios might reflect aggressive expansion via debt, while high ratios suggest cautious, self-funded growth.

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Related Metrics

• Debt-to-Equity Ratio (D/E): Inverse perspective (Liabilities ÷ Equity). For the example above, D/E = ₹4,00,000 ÷ ₹6,00,000 = 0.67. Lower D/E aligns with a higher equity ratio.
• Debt Ratio: Complement to equity ratio (Liabilities ÷ Total Assets). Here, ₹4,00,000 ÷ ₹10,00,000 = 0.40 (40%). Equity Ratio + Debt Ratio = 100%.

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Real-World Context (India)

• Tata Steel (2024 estimate): Assets ≈ ₹2.7 lakh crore, Equity ≈ ₹1.1 lakh crore → Equity Ratio ≈ 41%. Reflects heavy industry’s debt reliance.
• Infosys: Assets ≈ ₹1.5 lakh crore, Equity ≈ ₹1.2 lakh crore → Equity Ratio ≈ 80%. Shows tech’s cash-rich, low-debt model.

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Limitations

• Static Snapshot: Based on balance sheet data at one point—doesn’t reflect cash flow or profitability.
• Asset Valuation: Inflated or outdated asset values can skew the ratio.
• Industry Bias: A “good” ratio varies—50% might be solid for manufacturing but low for services.

In short, the equity ratio is a simple yet powerful tool to see how much of a company stands on its own feet versus leaning on borrowed legs. It’s all about balance—too high or too low depends on what you’re aiming for!