Equity Ratio – How to Calculate It

The equity ratio is one of those financial terms and key performance indicators that every business owner should be familiar with. It provides valuable insight into a company’s financial health and helps assess how much loss a business can endure before facing insolvency or bankruptcy risk. It’s also an important metric in determining the terms on which a company can secure external financing, such as loans or investor funding.

In this article, we’ll explore the equity ratio from all angles. We’ll find out what constitutes a good equity ratio and when you should be concerned about it. Additionally, we’ll give you clear instructions on how to calculate your company’s equity ratio yourself, tailored for businesses operating in New Zealand.

What Does Equity Ratio Mean?

Financial terminology can sometimes be confusing for new entrepreneurs, but the equity ratio is essentially a straightforward concept. It measures precisely what the name suggests: the proportion of a company’s own capital compared to borrowed or external capital.

The higher the equity ratio, the better the company is able to operate relying on its own funds. The equity ratio reveals the company’s capital structure and financial independence. A company with a high equity ratio is largely self-financed and does not depend heavily on outside financing to continue its operations.

When a company has a high equity ratio, it is considered financially sound or solvent. In financial terms, this is essentially the opposite of being highly leveraged or heavily in debt. Thus, the equity ratio is a useful tool for evaluating a company’s financial standing, much like debt-to-equity ratios or other leverage indicators.

How Is the Equity Ratio Calculated?

There is a commonly accepted formula to calculate the equity ratio, widely used in financial analysis to evaluate a company’s financial condition. You can calculate your own company’s equity ratio using this formula:

Equity Ratio (%) = (Equity / Total Assets) × 100

Here’s what the components mean:

Equity includes shareholder equity, retained earnings, reserves, and any other owner’s capital recorded in the balance sheet. It may also reflect adjustments such as revaluation reserves, depending on accounting practices.
Total Assets are the sum of all current and fixed assets the company owns, as shown on the balance sheet.

In some cases, especially if there are advance payments or deposits received from customers that significantly impact liabilities, these may be adjusted when calculating total assets for a more precise picture. However, in many cases, this adjustment is minor and can be omitted for simplicity.

It’s important to note that the market value of assets may differ from the book value reported in accounting records. If the market value is substantially higher, businesses may adjust equity accordingly for a more realistic financial assessment.

Interpreting the Equity Ratio

Once you’ve calculated the equity ratio, the next step is understanding what it means for your business. Here are general benchmarks used in financial analysis:

Above 50% – Excellent
Above 40% – Good
Above 30% – Satisfactory
Above 20% – Fair
Below 20% – Weak

If your company’s equity ratio falls into one of the top two categories, it means your business can weather potential losses for an extended period without the threat of insolvency. You have sufficient financial depth to cover downturns using your own funds without needing external financing.

Conversely, if your equity ratio is below 20%, your business carries significantly higher financial risk. Unexpected changes, such as sudden drops in revenue or increased costs, become harder to absorb. Such companies often need to seek business loans, which add extra costs and financial burdens.

Why the Equity Ratio Matters to Investors

Besides helping you self-assess your company’s financial health, the equity ratio is also popular among investors searching for their next investment opportunity.

Less experienced investors might be attracted by a company’s impressive profit figures reported on the income statement and assume it’s a successful business. However, the income statement alone does not tell the whole story. A company might have strong profits but also carry heavy debt, revealed only through balance sheet analysis.

On the flip side, a company reporting losses might still be financially stable if it has a strong equity base. Businesses with high equity ratios can continue operating profitably over the long term, withstanding economic fluctuations with less risk. This makes them a safer investment option, often classified in a lower risk category.

The Equity Ratio and Business Loans in New Zealand

Financial institutions, including banks and alternative lenders, pay close attention to the equity ratio when assessing loan applications. It’s a key factor in determining whether a business qualifies for credit and under what terms.

In New Zealand, banks typically require a healthy equity ratio as a sign of financial stability. A high ratio reduces perceived risk and may lead to better interest rates, longer repayment terms, and larger loan amounts.

Companies with low equity ratios might still secure loans but will likely face stricter conditions. These may include higher interest rates, shorter loan periods, additional collateral requirements, or loan caps.

Non-bank lenders or finance companies often offer more flexible loan options to businesses with weaker equity ratios but compensate for the risk by charging higher interest rates and imposing tighter repayment terms.

When applying for a business loan through financial service platforms or brokers in New Zealand, analysts will review your equity ratio alongside other financial metrics to match you with lenders whose risk appetite fits your business profile.

The Impact of Company Age on Bankruptcy Risk

Just like with many other financial indicators, the equity ratio shouldn’t be looked at in isolation. Many factors influence a company’s future outlook, and one of the most important is how long the business has been operating.

A low equity ratio is generally a reliable indicator of a higher risk of insolvency, but this is less true for startups and younger companies. Many new businesses carry deliberate debt taken on as part of their growth strategy or startup funding.

For young companies, more emphasis is placed on profitability and cash flow projections. A negative equity ratio (where liabilities exceed assets) is a more serious warning sign, regardless of how long the business has been running.

Why One Year’s Equity Ratio May Not Tell the Full Story

When analyzing equity ratios, be cautious about relying on a single year’s balance sheet data. This snapshot represents the company’s financial position on one particular day and may be affected by unusual or non-recurring events.

If possible, it’s wise to examine the median or average equity ratio over multiple years—ideally three to five. This approach smooths out anomalies and offers a clearer picture of the company’s true financial stability.

Additionally, complement your analysis with other financial ratios such as debt-to-equity, interest coverage, and liquidity ratios to form a comprehensive risk assessment.

How to Improve Your Equity Ratio

If your equity ratio is lower than desired, there are several ways to improve it and strengthen your business’s financial health:

Reduce debt by repaying loans or refinancing on better terms.
Increase equity through retained earnings, issuing new shares (if applicable), or capital contributions from owners.
Sell or write off non-productive assets to optimize your balance sheet.
Improve operational efficiency and reduce costs to generate higher profits that can boost retained earnings.
Explore government grants, subsidies, or innovation funds available to New Zealand businesses, especially for SMEs and startups.

Implementing these strategies can steadily improve your equity ratio, enhance your company’s creditworthiness, and facilitate access to more favourable financing options.