When you and your spouse review a company’s financials to consider buying stock, you can check its target equity ratio to determine the amount of risk it aims to employ. A company’s equity ratio measures the percentage of its assets it finances with stockholders’ equity and indicates its level of financial strength and risk. A company establishes a target, or desired, equity ratio as a guideline to help management maintain a certain level of equity.
The Equity Ratio
A higher equity ratio generally indicates less risk and greater financial strength than a lower ratio. If a company’s equity ratio is high, it finances a greater portion of its assets with equity and a lower portion with debt. Equity is safer than debt because it does not require interest payments and does not need to be repaid. If a company’s equity ratio gets too low, it may be taking on too much debt, which might result in bankruptcy.
Equity Ratio Calculation
A company’s equity ratio equals its total stockholders’ equity divided by its total assets, both of which it reports on its balance sheet. For example, if a company has $7.5 million in total stockholders’ equity and $10 million in total assets, its equity ratio would be 0.75, or 75 percent. This means it finances 75 percent of its assets with equity and finances the remaining 25 percent with debt, which represents relatively low risk to stockholders.
About a Target Equity Ratio
A company typically selects a target equity ratio that generates the most profits without taking on too much risk. A target that is too high might be too conservative, while one that is too low might be too aggressive. If a company chooses to disclose its target equity ratio to stockholders, it typically discusses it in its annual report. If a company’s actual equity ratio strays from its target, it can take measures, such as raising more equity, to adjust it.
Analyzing the Target Equity Ratio
Compare a company’s target equity ratio with those of other companies in its industry to determine an appropriate level it should maintain. If a company sets a target equity ratio that is significantly lower than the industry standard, it may be taking on too much risk. You can also compare a company’s target equity ratio to its actual equity ratio to determine how well it is achieving its goals. A company that consistently meets its target equity ratio maintains good discipline in managing its finances.
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