Businesses have two major options when it comes to financing. They can issue equity in exchange for cash or take on debt. The net assets to total assets ratio highlights how much of a business is comprised of equity versus loans and other liabilities. A net assets to total assets ratio that is high means more available funds, while a company with a low ratio is less solvent.
The net assets to total assets ratio measures the percentage of equity in a company relative to its total capital structure. This ratio, along with other solvency and structural ratios, is used by creditors and potential investors when deciding whether to issue a loan or invest. The net assets to total assets ratio is the inverse of the debt ratio, which measures the amount of debt the company holds relative to its total capital structure.
Total assets is the sum of every asset account. Most companies hold both short-term assets, like accounts receivable, cash and inventory, along with long-term investments, equipment and buildings. Net assets equals total assets minus total liabilities. Net assets is also referred to as total equity. To calculate the ratio, divide net assets by total assets. For example, a company with net assets of $50,000 and total assets of $100,000 has a net assets to total assets ratio of 0.5.
Understanding a Low Ratio
A net assets to total assets ratio of less than 0.5 means that the company holds more liabilities than it does equity. Liabilities are amounts the company is obligated to pay, so a high level of liabilities is a concern to lenders. Banks are hesitant to lend to companies that already hold a large amount of outstanding debt relative to available funds because they may not be able to pay back monies owed. A bank may lend to a company with a low ratio, but they will most likely charge a higher interest rate to compensate for the additional risk.
Understanding a High Ratio
Conversely, companies with a net assets to total assets ratio above 0.5 have more available assets than they have liabilities. Creditors like to see a high ratio because it provides more assurance that loans will be paid back. Investors also like to see a high ratio because more available funds means more opportunities for growth and expansion and to pay dividends to investors. Companies with a high ratio will enjoy lower interest rates on loans and potentially higher stock prices.
- Michigan State University: Equity-to-Asset Ratio
- MyAccountingCourse.com: Equity Ratio
- Ready Ratios: Equity Ratio
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Based in San Diego, Calif., Madison Garcia is a writer specializing in business topics. Garcia received her Master of Science in accountancy from San Diego State University.