The equity-to-assets ratio is one of many financial ratios used to determine the financial health and long-term profitability of a corporation. It is often used by investors to determine whether the corporation's shares are a safe investment. Though important, the equity-to-assets ratio should be used only with other financial ratios to determine a corporation's overall financial health.
Equity vs. Assets
Equity represents the total current value of the money invested in the corporation by all of its shareholders -- the cumulative value of all of its shares, in other words -- plus any retained earnings generated by its operations. A corporation can increase its equity by turning a profit or by issuing new shares. It can decrease it by buying back its own shares, buying assets or operating at a net loss. Assets represent the entire value of the corporation, such as its equity, its inventory, its accounts receivable and any revenue generated from loans.
The equity-to-assets ratio is the value of the corporation's equity divided by the value of its assets. A high ratio means that the corporation is mostly owned by its shareholders, while a low ratio means that the corporation is likely burdened with high debts. An equity-to-assets ratio of below 0.70 generally makes it difficult for a corporation to borrow money, due to concerns about its solvency.
Solvency and Bankruptcy
Solvency is a term that generally refers to a corporation's ability to meet its debt obligations if it converted all of its assets into cash to pay creditors. The equity-to-assets ratio is a precise measure of solvency. If a corporation approaches insolvency, its creditors might petition a court for involuntary Chapter 7 bankruptcy to ensure repayment. If the court accepts the petition, the corporation's assets will be sold to satisfy its debts, and the value of its shares will drop to zero.
The equity-to-assets ratio can mislead a prospective investor under certain circumstances. A corporation might take on high levels of debt to take advantage of emerging business opportunities, or it may reinvest loan revenue into an investment with a higher return than the interest it pays on the debt. Likewise, a high equity-to-assets ratio does not necessarily mean the corporation enjoys good financial health -- it may be falling behind its competition in an industry that requires high levels of investment that cannot be financed using its equity alone.
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