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What’s it: The asset-to-equity ratio is a financial ratio indicating the extent to which a company’s assets are financed through equity. We calculate it by dividing total assets by equity.
We can find this ratio in the DuPont decomposition, calling it the financial leverage ratio. It relates this ratio to the return on equity (ROE).
A low asset-to-equity ratio indicates the company relies on equity capital to finance the growth of its assets. Conversely, if it is high, the company depends on debt capital. A ratio above 2 shows that debt contributes more to financing assets than equity.
How does the assets-to-equity ratio work?
The company finances its assets through two sources: equity and debt. Equity represents ownership in the company. It is contributed by shareholders or stock investors.
Meanwhile, debt represents a liability, where the company must pay off interest and debt in the future. Debt can come from bank loans, commercial paper, medium-term notes, or bonds.
Unlike equity, a company must repay debt regardless of its financial condition and performance. Take bonds, for example. The company pays coupons regularly, on a quarterly or semi-annual basis. And at maturity, the company must pay off the principal. Moreover, payments must be made even when the company is not generating revenue. In other words, debt creates a fixed financial burden for the company.
For such reasons, increased debt increases financial risk. If a company takes on too much debt, it can increase the risk of default. Its financial flexibility also decreases because it has to allocate more money to pay off debt. In addition, the company may find it difficult to raise further capital through new debt.
To check how dependent a company is on debt and equity, we can measure it by the assets-to-equity ratio. It tells us the number of times a company’s assets are financed through equity instead of debt.
How to calculate the assets-to-equity ratio?
Calculating the assets-to-equity ratio is easy because it only requires arithmetic operations, and the data is already available in the financial statements. We calculate this ratio by comparing total assets to total equity. Both are on the balance sheet. Total assets include short-term and long-term assets, both tangible and intangible.
- Asset-to-equity ratio = Total assets / Total equity
Take a simple example. A company reports total assets of $6 million and total equity of $4 million. Thus, its asset-to-equity ratio is 1.5 = $6 million / $4 million.
How to interpret the assets-to-equity ratio?
A high ratio shows the company is quite dependent on debt. A low ratio indicates the opposite condition. If it is equal to 2, equity and debt finance assets in equal proportions. If it is higher, the company is more dependent on debt than equity. Conversely, if it is lower, equity has a larger proportion.
If the assets-to-equity ratio increases, the company takes on more debt than equity. Conversely, if it decreases, equity increases higher than debt.
A low ratio indicates asset growth is financed conservatively, which is common for companies with small and unstable cash inflows. Adding debt can worsen their finances unless they can add more money with it.
Take the example of a new company. They have not generated sufficient cash flow at the start of operations. Thus, to support operations, they rely on equity capital from their shareholders. Over time, they may take on debt as their cash flows are more stable. Debt can finance the expansion they need to support higher incomes in the future.
In contrast, companies with stable cash flows, such as utility companies, tolerate high ratios. Thus, they should find it easier to pay off debt with consistent cash flow.
However, taking on too much debt increases financial risk. Suppose the additional debt is not accompanied by additional higher cash inflows. In that case, it worsens the company’s ability to pay and can lead to default. The risk is higher if interest rates rise because it increases their burden. In addition, deteriorating sales due to tougher competition or a worsening economy can adversely affect their ability to pay off debt.
How does this ratio relate to ROE?
The two-stage decomposition shows us the relationship between ROE, ROA, and financial leverage ratios. ROE is defined as ROA times the financial leverage ratio.
- ROE = ROA x Asset-to-equity ratio
Net profit/Total equity = (Net profit/Total assets) x (Total assets/Total equity)
The above equation shows a positive relationship between financial leverage and ROE. Higher financial leverage increases ROE.
A high financial leverage ratio means the company is quite dependent on debt. Thus, we might say having high debt contributes positively to higher returns on equity. When increasing debt, the company pays higher interest. Since interest expense is tax-deductible, less profit is paid as tax.
Of note, such a relationship holds if new debt generates more profit. In other terms, it yields a higher marginal return than the additional cost of the debt.
However, if the new debt yields a lower marginal return than the additional cost of debt, taking on more debt will depress ROE. This is because the company bears a higher burden than the cash generated from the additional debt.
