All businesses require assets to generate revenues. However, the particular assets a business chooses to employ varies greatly from one industry to another, as does the manner in which a firm finances its assets over the long term. In particular, some companies acquire fixed assets through the assumption of long-term debt and others through equity. Leverage ratios are used to illustrate the relative exposure of the shareholders of a business as opposed to its creditors. One such ratio is the fixed-assets-to equity ratio, which measures the ability of a business to rely on both the direct investments in a company and its retained earnings to acquire long-term assets.
The fixed-assets-to-equity ratio is one type of leverage ratio. It divides a company's fixed assets by its owners’ equity. In this instance, fixed assets refer to a firm's plant, property and equipment, the lifetime of which is three or more years. In turn, shareholder equity includes retained earnings from income generated by the company and paid-in capital.
The financial stability of a company as well as its risk of insolvency can be gauged using equity ratios. The fixed-assets-to-equity ratio in particular measures the relative exposure of shareholders vs. the creditors of a business. Financial leverage increases the business risk of a company in that debt leads to fixed costs that potentially can have a negative effect on profitability in the event that revenues sharply decrease. In addition, the fact that debt and interest takes priority over other business interests can have a negative impact on future operations should the company’s revenue stream dramatically shift for the worse. As a result, the assets-to-equity ratio provides essential information to potential creditors.
An ideal fixed-assets-to-owners-equity-ratio does not exist. However, a company whose debt is equal to or greater than the value of its assets is not considered to be a good investment. This is true in part due to the debt service obligation that is associated with both short- and long-term debt, which gives rise to the possibility that a firm will be unable to meet its debt obligation in a timely manner. For example, an assets-to-equity ratio that is greater than 100 percent is an indication that a large percentage of a company's productive capacity is financed by long-term loans rather than investments of shareholders and retained earnings. As a rule of thumb, a 65 percent ratio is appropriate for many businesses.
Fixed assets to equity equals fixed assets divided by total shareholder equity. If fixed assets equals 32,050 and total shareholder equity equals 99,458, fixed assets to equity equal 32,050 divided by 99,458, or 32.33 percent.
- "Valuation Workbook"; James R. Hitchner and Michael J. Mard; 2011
- "Valuing a business: The Analysis and Appraisal of Closely Held Companies"; Shannon P. Pratt and Alina V. Niculita; 2008
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