When you're evaluating a potential company as an investment, the balance sheet matters, but it can also get very complicated. A simple way to look at a company's debt obligations is to examine its equity-to-asset ratio, a measure that can tell you the extent of a company's leverage. Read on to learn more about this means of judging a company's financial fitness.
What is the equity-to-asset ratio?
The equity-to-asset ratio is a measure of how much of a company's assets are owned by investors and how much of a company's assets are leveraged. This is a really important ratio because you don't want to be investing in a company that's doing a lot of heavy borrowing just to stay in business.
If a company is instead looking to investors to help pay the bills, then it's owned by its owners and not effectively by its debtors. If a bankruptcy were to occur, the debtors would be taking a big chunk of the assets of a highly leveraged company, but the investors would get some amount of their investment back in a company that was primarily investor-funded.
Some companies have higher or lower equity-to-asset ratios, depending on the industry, so be sure to compare the company that interests you to its competitors so you can tell if the company is on par with the rest of the market.
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Why the equity-to-asset ratio matters to investors
As mentioned above, the equity-to-asset ratio of a company gives you a general idea of how much of the company is actually owned rather than leveraged. The less debt a company has, the better that generally is for its longer-term health. There are exceptions, of course, but it's usually better to have less debt than more debt.
When you know that your company has 80% of its assets free of debt, you also know that 20% are encumbered. This can help you better plan if the ship starts to sink. Stockholders are often among the last to be compensated during a bankruptcy sale since debtors are generally first in line and may consume a great deal of the remaining value of the company while satisfying debt. If you're in doubt, choosing companies with high equity-to-asset ratios means you're more likely to have some kind of return -- even during bankruptcy -- than you would from a company with a very low equity-to-asset ratio.
However, this has to be a calculation you perform while looking at other things, too. There are no financial ratios that exist inside a vacuum. A company is generally a mix of good and bad, and you have to decide if the good outweighs the bad after all kinds of numbers are examined, including the equity-to-asset ratio.
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