Equity ratio is often used to assess a company’s financial strength, and it is often used as a financial covenant in loan agreements, so it is extremely important what it really means.
Myth 1 – High equity ratio confirms company’s financial strength.
Many think that high Equity ratio normally means there is a huge amount of money parked in company’s assets.
But that does not have to be true.
Money can be invested in assets which are not of much value – doubtful receivables, obsolete inventories, goodwill, or outdated fixed assets…
Think of the ratio’s numerator and what it consists of.
Normally the largest element of the shareholders’ equity is retained earnings.
But retained earnings are generated over time in the income statement, not cash flow.
That means that although profit is there, there might not be enough cash to pay it out.
Think also about the Equity ratio’s denominator: Total assets.
Total assets cover so many things, and that amount does not necessarily represent the actual value of company’s assets.
Think only about how different asset valuation methodologies can be, or how some balance sheets can be inflated or undervalued.
Myth 2 – If a company bankrupts, high equity ratio means there will be enough value to cover creditors’ exposure.
If a company cannot service its debt, that often means that the assets a company owns do not generate enough cash flow.
If an asset does not generate enough cash flow – how much is it worth?
Don’t forget that asset value drops significantly when a company bankrupts.
There is a reason why banks sell their NPLs often at 20% of their exposure, or even less…
This means that the Equity ratio of 30-40% of a bankrupted company normally means any shareholders’ value will be wiped out…
Would you be surprised if I told you that none of the rating agencies has the Equity ratio prescribed in their methodologies?
There is no typical amount of equity which should be in a company’s balance sheet.
There is only maximum amount of debt which should be there.
High amount of debt is one of the major reasons why companies bankrupt.
So, when somebody asks you how much equity should they have – flip the question by asking – how much debt could they handle?
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