Advantages Of A Low Equity Ratio
There is generally only one important argument for low equity ratios. The leverage effect claims that a low equity ratio leads into rather higher equity yields.
Advantages Of A High Equity Ratio
A higher equity ratio of one company generally indicates a low dependency on creditors. As a consequence interest payments are low and the dept ratio is very often also quite low for such companies. Another consequence of a high equity ratio is then often also the fact that future profits do not need to be used for interest payments but may be used for payments to the shareholders instead. A high equity ratio also limits the risk of bankruptcy as periods with a loss can be survived in a better way compared to companies with an already lower equity ratio. Rating agencies therefore like the equity ratio as a key performance figure to measure the credit rating of companies. Low equity ratios lead into negative ratings and high equity ratios lead into rather positive ratings.
Discussion Equity Ratio
One important point is to always remember that equity ratios of different companies in different sectors are difficult to be compared. For example financial companies generally have to deal with lower equity ratios which is mainly caused by this special financial sector business concept. In such cases a comparison of equity ratios should only be done within one and the same economic sector. However Finanzoo.de does not conduct any "sector cleaning" when calculating the FScore. There is no equity ratio bonus of any kind for sectors with low key performance figures in this field. The final decision how to deal with such sector specific factors completely remains with the user. Please also be aware that there is strong empiric evidence for some kind of relationship between company size and equity ratio. Bigger companies seem to generally have a higher equity ratio than rather smaller companies. Furthermore private companies seem to have a lower equity ratio than incorporated companies.
Increasing The Equity Ratio
The equity ration can be increased by a company with both measures on the liabilities side as well as on the asset side of the balance sheet. On the asset side for example equity releases will immediately lead into an increasing equity ratio. One of these measures is the selling of accounts receivable which is also know as factoring. On the liabilities side, capital increases and profit retentions can lead into an increasing equity ratio as well.
Typical Equity Positions
- Subscribed Capital
- Capital Reserves
- Retained Earnings
- Profits brought forward
- Annual Net Profits
Typical Loan Capital Positions
- Accruals, e.g. Pension Accruals
- Subordinated Loans
- Participation Rights
- Silent Partnerships
- Hybrid Bonds
- Shareholder Loans
Distinction Of Equity And Loan Capital
In order to calculate the equity ratio a clear distinction of equity and loan capital is absolutely necessary. A good rule of thumb is to consider all balance sheets positions as loan capital that include any kind of repayment possibility. Examples:
The calculation of the FScore puts the equity in relation to the total capital invested of one company. High scores are being reached for values of more than 50%. The equity ratio has a share of 20% within the Fscore.
Equity Ratio - E/R
The equity ratio shows the equity in relation to the total capital invested. The equity ratio as a key performance figure stands for the financial stability and for the dependency on loan capital of one company. A high equity ratio is generally considered as a sign for a high financial stability and as a low dependency on loan capital. Additionally also the credit rating of companies increases with increasing equity ratios. Consequently the possibilities to receive loan capital are increasing as well. Companies with high equity ratios generally do not face problems with increasing interest rates as many companies with low equity ratios do. Equity ratios of more than 30% are considered as good.