Asset equity ratio

Asset equity ratio
See also

Asset equity ratio is an indicator of the extent to which equity capital covers fixed assets. Equity should be sufficient to finance fixed assets, and the ratio should be at least 1. If the ratio is less than 1, this means that part of the assets is financed by foreign capital, which indicates the company's financial disadvantage. Together with other indicators, it helps assess the risk of a financial disadvantage. The equity participation rate in the financing of fixed assets is one of the capital structure indicators in the fundamental analysis. It indicates the degree of financing of fixed assets from the company's capital. The equity to asset ratio is calculated by dividing equity by fixed assets and the values are expressed as a percentage [1].

Formula of the ratio:

equity capital / fixed assets x 100%

Fixed assets are very illiquid assets and are therefore not very flexible in the face of market fluctuations. Fixed assets are therefore considered to be high-risk and should be covered (financed) as much as possible by the company's equity. The highest possible value of this indicator is desirable. The higher the equity coverage of fixed assets, the more creditors can count on the recovery of their contribution to the company even in the event of its liquidation, because the equity coverage of fixed assets in excess also partially finances current assets [2]. A company with a high value of the ratio has a higher creditworthiness. The value of the ratio should not be lower than 100%.

Equity capital

Equity capital is the equity of investors in a company. It is the value of economic resources contributed to the company by the owners (shareholders, shareholders, partners) and resources generated by the company in the course of its activity. Equity capital (fund) includes [3]:

  • entrusted capitals (funds) - these are original financial or in-kind contributions (in-kind contributions) of the owners, made at the moment of establishing the business entity, but they may be later supplemented (increased),
  • self-financing capitals (funds) - arise from the profit earned and retained in the company or from other sources characteristic for a given activity.

In the financial reporting of companies, equity capital includes such capitals as [4]:

  • the capital of the company,
  • share capital,
  • reserve capital,
  • revaluation reserve,
  • undistributed profit or uncovered loss from the financial year and previous years,
  • net profit (loss) for the current financial year.

Fixed assets

Fixed assets, i.e. land, buildings, structures, machinery and equipment, constitute the basis for conducting business activity in the company. If they are financed with equity, there is little risk of losing business. Therefore, the golden balance sheet rule states that fixed assets should be financed 100% with equity [5].

Application of the asset equity ratio

The fixed capital participation rate in the financing of fixed assets is used to determine the equity participation in the financing of the total assets of the economic unit. It indicates the degree of financing of fixed assets from the company's capital supplemented by long-term liabilities. It also allows to determine whether the equity value of the company is sufficient to finance fixed assets. It makes it possible to check whether the so-called golden financial rule, according to which fixed assets should be financed with long-term capital, i.e. capital which is at the disposal of the company for over 1 year, has been observed in the company [6].

The higher the value of the ratio, the greater the financial security of the company. If it is greater than 1, it means provided long-term liquidity. The indicator measures the share of equity in the total sources of financing for the activity, hence it allows to assess the degree of financial independence of the company [7]. Its value can also be interpreted in the context of securing repayment of debt with assets held. With a low share of equity in total assets (i.e. automatically a high share of debt), we assess the security of liabilities repayment as low. At high and increasing values of the ratio, it is advisable to additionally assess the debt structure due to its maturity - a high share of long-term debt encumbers solvency to a greater extent [8].

Interpretation of the indicator

The high value of the ratio and the upward trend are interpreted as the improvement of the financial independence of the company and the improvement of the security of debt repayment with the owned assets. A low ratio and a downward trend are interpreted respectively as a deterioration in the financial independence of the company and a deterioration in the security of debt repayment with its assets (reduction in debt capacity) [9].

Footnotes

  1. A.E. Nasution 2019, pp. 3
  2. A.E. Nasution 2019, pp. 5
  3. F. Affandi 2019, pp.121-123
  4. F. Affandi 2019, pp.121-123
  5. Kamar K. 2017, pp. 54 - 55
  6. D.M.R. Tari 2018, pp. 23
  7. D.M.R. Tari 2018, pp. 23-24
  8. D.M.R. Tari 2018, pp. 24
  9. T. Velnampy 2012, pp. 66

References

Author: Aleksandra Morzywołek