What is the Asset to Equity Ratio?

The asset to equity ratio reveals the proportion of an entity’s assets that has been funded by shareholders. The inverse of this ratio shows the proportion of assets that has been funded with debt. For example, a company has $1,000,000 of assets and $100,000 of equity, which means that only 10% of the assets have been funded with equity, and a massive 90% has been funded with debt.

How to Calculate the Asset to Equity Ratio

To calculate the asset to equity ratio, divide total assets by total equity. A variation on the concept is to strip out all intangible assets, thereby focusing attention on the proportion of tangible assets being funded with equity. The formula is:

Total assets ÷ Total equity = Asset to equity ratio

Example of the Asset to Equity Ratio

Lightning Corporation, maker of lightning rods, has total assets of $400,000 and total equity of $100,000. The resulting asset to equity ratio is 4:1, which indicates that the company is using a substantial amount of debt to fund the purchase of its asset base. The company’s cash flows tend to be highly variable, which means that it is at increased risk of being unable to pay this debt. Consequently, the ratio is a good indicator of financial instability for this business.

Understanding the Asset to Equity Ratio

A low ratio indicates that a business has been financed in a conservative manner, with a large proportion of investor funding and a small amount of debt. A low ratio should be the goal when cash flows are highly variable, since it is quite difficult to pay off debt in this situation. A higher ratio is tolerable when a business has a long history of consistent cash flows, and those cash flows are expected to continue into the future.

A high asset to equity ratio can indicate that a business can no longer access additional debt financing, since lenders are unlikely to extend additional credit to an organization in this position. Also, if a business has a high ratio, it is more susceptible to pricing attacks by competitors, since it must maintain high prices in order to generate the cash flow to pay for its debt.