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The Equity Ratio
A key figure for financial stability
Equity should yield better returns than debt in a healthy capital market. Within a company, capital is just capital, but the equity ratio provides an indication of how a company finances itself, whether conservatively or more aggressively.
The equity ratio:
It represents the share of equity in the total capital of a company. Equity is the denominator and the balance sheet total is the numerator. Please note that low indebtedness says nothing about the quality of a share. Debt can be found in every major balance sheet.
The benefits of debt capital:
Debt capital is tax deductible, as interest on debt reduces the tax burden. Anyone who rents out a house or apartment is familiar with this advantage. However, as the proportion of debt capital increases, so does a company’s risk, as the interest burden grows. Success is no longer a bonus, but a necessary obligation. In economic downturns, debt capital becomes a boomerang. Important: The more cyclical the business and the lower the margins, the more equity should be maintained.
Pay attention to the right mix:
In times of low interest rates and boom phases, executives tend to have lower equity ratios. This is acceptable for less volatile business models, such as in the consumer industry, but extremely dangerous for cyclicals.
The Facts:
- When the equity is put in relation to the balance sheet total, the equity ratio is obtained.
- A high equity ratio often characterizes conservative companies.
- Isolated, it does not represent a quality feature.
- Debt capital interest is tax deductible, thus profitability and, in moderation, absolutely sensible.
Our Conclusion:
A certain proportion of debt capital in the balance sheet is correct and sensible. It is often also cheaper than equity, which is raised, for example, through a capital increase. However, once the interest payments reach a level that is existential-threatening even during brief downturns, it becomes absurd. If a company needs to take on new debt to settle old debts, then you should not invest. Please consider what a small increase in interest can mean for a society whose equity ratio is in the single-digit range.
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