Asset equity ratio

From CEOpedia | Management online

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].

Examples of Asset equity ratio

  • Asset to equity ratio can be used to compare the liquidity of different companies. For example, a company with a ratio of 1.5 means that for every dollar of fixed assets, there is $1.50 in equity. This indicates that the company has higher liquidity than a company with a ratio of 1.0.
  • Asset to equity ratio can also be used to measure the financial health of a company. For example, a company with a ratio of 0.5 means that for every dollar of fixed assets, there is only $0.50 in equity. This indicates that the company is not in a healthy financial situation and is at risk of defaulting on its debts.
  • Asset to equity ratio can also be used to measure the risk of a company. For example, a company with a high ratio (greater than 1.0) may be more vulnerable to market fluctuations and may have difficulty financing future growth. On the other hand, a company with a low ratio (less than 1.0) may have difficulty accessing capital and may be more likely to default on its debts.

Advantages of Asset equity ratio

The main advantages of the asset equity ratio are:

  • It is a reliable indicator of the financial health of a company. It helps to determine the degree of financing of fixed assets from the company's own capital, which is an important factor in assessing the risk of financial instability.
  • It helps to assess the risk of financial disadvantage, as it indicates the extent to which equity capital covers fixed assets.
  • It helps to compare the capital structure of different companies, as it provides an indication of the proportion of equity financing relative to the fixed assets.
  • It helps to identify potential areas for improvement in the company’s capital structure, such as identifying potential sources of equity capital or reducing the ratio of fixed assets to equity.
  • It helps to identify potential risks associated with the capital structure of a company, such as the risk of insolvency or a decrease in profitability.

Limitations of Asset equity ratio

  • The asset equity ratio does not take into account any liabilities associated with the assets. This means that the ratio does not provide an accurate picture of the company’s total financial health.
  • The asset equity ratio does not take into account the liquidity of the assets. This means that the ratio can overestimate the value of the company’s assets if they are not able to be easily sold or converted to cash.
  • The asset equity ratio can be easily manipulated by management. For example, management can reduce their equity by issuing dividends or by repurchasing shares, which will increase the asset equity ratio.
  • The asset equity ratio does not take into account the company’s ability to generate profits or the quality of the assets. This means that the ratio can be misleading if the company has low-quality assets or is unable to generate profits.

Other approaches related to Asset equity ratio

  • Debt-to-assets ratio: This ratio measures the proportion of a company’s assets that are financed by debt. A high debt-to-assets ratio is seen as a sign of risk since creditors may be reluctant to lend to the company, and the company may be unable to repay its debts.
  • Debt-to-equity ratio: This ratio measures the proportion of a company’s equity that is financed by debt. A high debt-to-equity ratio indicates that a company is highly leveraged and is more likely to default on its debts.
  • Return on assets ratio: This ratio measures the return that a company earns on its assets. A high return on assets indicates that the company is generating more income from its assets than it is spending.
  • Return on equity ratio: This ratio measures the return that a company earns on its equity. A high return on equity indicates that the company is generating more income from its equity than it is spending.

In summary, other approaches related to asset equity ratio are debt-to-assets ratio, debt-to-equity ratio, return on assets ratio, and return on equity ratio. These ratios help to measure the financial health and stability of a company by looking at the proportion of assets and equity that are financed by debt and the return earned on these investments.

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


Asset equity ratio — recommended articles
Debt management ratio — Debt to total assets ratio — Capitalization ratios — Capitalization ratio — Degree of financial leverage — Return on net assets — Asset coverage ratio — Ebitda ratio — Solvency ratios

References

Author: Aleksandra Morzywołek

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