Formula
Equity to Fixed Assets Ratio = Equity / Total Fixed Assets
- Equity includes the retained earnings
- Total Fixed assets excludes intangible assets of the firm
Meaning
The “equity to fixed assets” ratio shows analysts the relative exposure of shareholders and debt holders to the fixed assets of the firm. Thus, if the “equity to fixed assets” ratio is 0.9, this means that shareholders have financed 90% of the fixed assets of the company. The remaining 10% as well as current assets and investments have all been financed by debt holders.
Assumptions
There is an implicit assumption that the number of shares outstanding has remained unchanged. This is because the ratio measures the total amount of equity. The total amount of equity can be increased by issuing shares at lower prices to the public or to the promoters. However, this may not be a desirable scenario since more shares means a loss to individual shareholders.
Interpretation
The “equity to fixed assets” ratio is used by a variety of stakeholders for different purposes. The common interpretations that are drawn based on this ratio have been listed below:
- Creditworthiness: Bankers and other lenders use the “equity to fixed assets” ratio widely. They use it to understand how much of the fixed assets of the firm are already financed by debt. A firm with a low “equity to fixed assets” ratio has not utilized its credit to the maximum and therefore extension of credit is relatively secure. This is because in the event of a liquidation, the creditors have the first claim over the proceeds recovered from the assets.
- Conservative vs. Aggressive: What might be good news for the bankers may not be such great news for the equity shareholders. This is because if the firm has a very low “fixed assets to equity” ratio, it means that the firm is underutilizing its credit. This means that the shareholders could have achieved a higher rate of return in case the company managed its operations better and used credit to its advantage. Hence a high “equity to fixed assets” ratio is not a very good sign either.
- Less than 0.65 Not Recommended: Based on empirical evidence, certain analysts have concluded that companies that have a “equity to fixed assets” ratio of less than 0.65 are very risky bets. Companies where shareholders own less than 65% of the fixed assets are likely to cash strapped and debt ridden. These companies usually run into solvency and liquidity issues and therefore must be avoided.
