As a new investor, there are a few critical financial ratios to understand before making any purchases. Even if you trust the financial ratio figures your advisor provides, you should still know what they represent and what they can tell you about the business in which you’re considering investing.

What is asset equity ratio?

The asset equity ratio or debt-to-equity ratio is an investment leverage that measures the percentage of owned assets vs. what is financed through shareholders. You can find these numbers on the balance sheet of a company’s financial statements. 

Equity ratio calculator

To calculate the equity, use this formula: Equity ratio = Total equity/Total assets. 

If a company’s total assets are reported at $150,000 and the total liabilities are $50,000. Based on the accounting equation, we can assume the total equity is $100,000, which equates to a ratio of 67 percent. This means shareholders and not creditors own 67 percent of the company’s assets. So if the company were to sell all of its assets to pay off its liabilities, investors would retain ownership of 67 percent of its resources. Depending on the industry, this is a healthy ratio.

Keep in mind; certain industries are more capital-intensive than others. So specific industry benchmarks may determine what a “good” equity ratio is for them.

What is a good asset equity ratio?

As we mentioned above, what makes a healthy asset equity ratio is dependent on the industry. Generally speaking, though, a higher ratio value tends to make it a better investment. It shows that many shareholders consider the company to be a worthwhile investment, and it lets potential creditors know that the company is a reasonable credit risk.

Though it doesn’t mean you should avoid a firm with a low asset equity ratio. A low ratio indicates that a business has been financed conservatively, 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. 

Why does this matter to investors? 

Before investing in a company, you’ll want to understand their overall financial strength. To do this, consider their asset equity ratio. This ratio will tell you whether or not they manage their money effectively without incurring substantial debt. 

Companies with a higher equity ratio have more free cash on hand for expansions, growth, and dividends. Because there is less debt, the investors will end up with the remaining assets after all of the liabilities are paid off — making it an attractive investment.

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On the other hand, companies with low equity ratios may not be solvent, which means they may not have the ability to pay all bills on time without taping into their savings. They’re a higher risk in the eyes of creditors.

What the asset turnover ratio can tell you

Now that you understand the asset equity ratio let’s discuss the asset turnover ratio. The asset turnover ratio is the ratio of total sales or revenue to average assets.

Calculating the total asset turnover ratio will tell you how many sales are generated from each dollar of company assets. For instance, a ratio of 0.5 means that each dollar of assets generates 50 cents of sales.

Investors use the asset turnover ratio to compare similar companies in the same sector. The higher the asset turnover ratio, the more efficient a company is at generating revenue from its assets. Conversely, if a company has a low ratio, you can assume it is not efficiently using its assets to generate sales.

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