The asset/equity ratio shows the relationship of the total assets of the firm to the portion owned by shareholders, also known as owners equity. The asset/equity ratio indicates a company's leverage, the amount of debt used to finance the firm. A company's asset/equity ratio depends importantly on the industry in which it operates, its size, economic conditions, and other factors. There is no ideal asset/equity ratio. A relatively high asset/equity ratio may indicate the company has taken on substantial debt merely to remain in business. But a high asset/equity ratio can also point to a company that is wisely "trading on the equity." In other words, there is a high asset/equity ratio because the return on borrowed capital exceeds the cost of that capital. At some point, however, an asset/equity ratio can reach unsustainable levels, as the additional debt ratchets up interest costs and the deteriorating financial position puts the firm in jeopardy. By the same token, a low asset/equity ratio can indicate a strong firm that needs no debt, or an overly conservative company, foolishly foregoing business opportunities. |
