Businesses use financial ratios to assess their performance, gauge financial well-being and report accurately to shareholders. Shareholders and external investors are especially keen on financial ratios that measure a company’s equity. The cash to equity ratio is one such decision-making tool for shareholders and external investors.
To understand cash to equity ratio you must understand the terms "equity" and "cash flow." Equity is the value of a company in terms of the total assets available to that company. It is the total value of assets contributed by shareholders to form the assets of the company. Equity is also referred to as a business’ net worth, capital equity or shareholders equity. You arrive at this figure by subtracting the total liabilities from total assets.
Free cash flow is the amount of capital a company has left after making the operational expenditures. Operational expenditures are those expenditures needed to sustain the company at its prevailing growth rate. To establish the free cash flow you need to know the rate at which a company will grow by considering sales revenues and the expenditures. Thus free cash flow equals operating cash-operation expenditures.
The cash to equity ratio is the ratio of a company’s cash on hand against the total net worth of the company. It excludes the liabilities, expenditures and debts a company has already serviced. The cash to equity ratio is also a measure of the value or worth of a company to its shareholders. To arrive at the cash to equity ratio, you will subtract the capital expenditure, net working capital and debt service from the sum of net income and newly borrowed debt.
Investors and creditors use the cash to equity ratio for equity valuation. Equity valuation is the process of measuring the value of a company by evaluating its current assets against its current liabilities. The value of the assets and liabilities must be at the prevailing fair market value. Accountants and financial analysts typically use formulas such as dividend discount model, the dividend growth model and the price-earnings ratio.
