It allows investors to get an insight into their return if the company is liquidated and all the assets are sold off to pay creditors and shareholders. The formula for the shareholder equity ratio is Total Assets divided by Total Shareholder Equity. This ratio can help investors determine how much of the company is owned by its shareholders and how much has been funded through debt.
A company's shareholder equity ratio is considered a good indication of its long-term financial soundness if compared to the same industry's standard ratios. Suppose the ratio is close to 100%. In that case, it means that most of the company's assets have been financed with equity capital instead of debt, meaning that in the event of liquidation, shareholders will receive more of the company's financial resources.
However, equity capital does have its drawbacks, as it tends to be more expensive than debt and requires ownership dilution. It can also mean giving voting rights to new shareholders, which some investors may be wary of.
For example, if ABC Widgets Inc. had total assets of $3 million, total liabilities of $750,000, and total shareholders' equity of $2.25 million, then its shareholder-equity ratio would be calculated as follows:
Shareholders' equity ratio = $2,250,000 / 3,000,000 = .75, or 75%.
This ratio indicates that ABC Widgets Inc. financed 75% of its assets with shareholder equity, meaning that only 25% is funded by debt. If all the assets were liquidated and all debts paid, shareholders would retain 75% of the company's financial resources.
A shareholder-equity ratio is a valuable tool for investors to analyze and understand a company's financial strength and to assess how much of its assets are funded with stock versus debt. Although there are some drawbacks to using equity as opposed to debt, such as higher costs and dilution of ownership, it is often the preferred way for companies to finance their assets due to its potential for greater returns in the long run.