There are a multitude of financial ratios used by investors to measure the health of a company. Some measure cash flow and profitability, while others are used to determine the health of a company's balance sheet. The equity-to-asset ratio is one of the latter measurements, and is used to assess a company's financial leverage.
Of equity and assets
The balance sheet gets its name because it is the balance between assets and liabilities plus equity. The asset side measures all the resources holding economic value that can be converted to cash. This could include, but is not limited to, real estate, equipment, inventory, raw materials, and cash.
The equity side, on the other hand, is the difference between the value of a company's assets and all of its liabilities. A simple example would be the equity value of one's home, which is the value of the property minus the mortgage balance. In other words, equity is what would be left over after the asset is sold.
In a sense, the equity-to-asset ratio is just a simplified way to look at a balance sheet and to distill it down to answer one question: What percentage of a company's assets do investors own? The formula is: Net worth / Total Assets = Equity-to-Asset ratio.
For an example of an equity-to-asset ratio in action, we'll use the following sample balance sheet:
If we plug in the numbers in the formula we get the following asset-to-equity ratio: $105,000/$400,000 = 26.25%. In other words, the company owns a little over a quarter of its assets outright. The rest of the equity of its assets is technically controlled by debtholders.
What the equity-to-asset ratio tells us
Therein lies the key to the equity-to-asset ratio, which is to determine what percentage of a company's assets are owned by investors and not leveraged and therefore could come under the control of debtholders (such as banks) in the event of bankruptcy. The higher the equity-to-asset ratio, the less leveraged the company is, meaning that a larger percentage of its assets are owned by the company and its investors.
While a 100% ratio would be ideal, that does not mean that a lower ratio is necessarily a cause for concern. Some assets, such as those that generate stable income like pipelines or real estate, tend to carry higher leverage. Therefore, what's important about this metric isn't the number itself, but how it compares on a relative basis to peers in the industry.
The $15,978 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. In fact, one MarketWatch reporter argues that if more Americans knew about this, the government would have to shell out an extra $10 billion annually. For example: one easy, 17-minute trick could pay you as much as $15,978 more... each year! Once you learn how to take advantage of all these loopholes, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how you can take advantage of these strategies.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors based in the Foolsaurus . Pop on over there to learn more about our Wiki and how you can be involved in helping the world invest, better! If you see any issues with this page, please email us at knowledgecenter@fool.com . Thanks -- and Fool on!
The article Equity-to-Asset Ratio originally appeared on Fool.com.
Try any of our Foolish newsletter services free for 30 days . We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy .
Copyright © 1995 - 2016 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy .
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
