There are a multitude of financial ratios used by investors to gauge 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. These could include, but are not limited to, real estate, equipment, inventory, raw materials, and cash.

Equity, 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:

Assets

 Value

Cash and Equivalents

$100,000

Accounts Receivable

$50,000

Plant, Property and Equipment

$250,000

Total Assets

$400,000

   

Liabilities

 

Accounts Payable

$45,000

Debt

$250,000

Total Liabilities

$295,000

   

Total Equity

$105,000

   

Liabilities plus Equity

$400,000

If we plug this examples numbers into 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.

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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.


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