Accounting and Its Use in Business Decisions
Analyzing and using the financial results - the equity ratio
The two basic sources of equity in a company are stockholders and creditors; their combined
interests are called total equities. To find the equity ratio, divide stockholders' equity by total equities
or total assets, since total equities equals total assets. In formula format:
Equity ratio = Stockholders 'equity
Total equities
The higher the proportion of equities (or assets) supplied by the owners, the more solvent the
company. However, a high portion of debt may indicate higher profitability because quite often the
interest rate on debt is lower than the rate of earnings realized from using the proceeds of the debt.
An example illustrates this concept: Suppose that a company with USD 100,000 in assets could
have raised the funds to acquire those assets in these two ways:
Case 1
Assets |
$100,000 |
Liabilities Stockholders' equity |
$20,000 $80,000 |
---|---|---|---|
Case 2
Assets |
$100,000 | Liabilities Stockholders' equity |
$80,000 $20,000 |
When a company suffers operating losses, its assets decrease. In Case 1, the assets would have to
shrink by 80 per cent before the liabilities would equal the assets. In Case 2, the assets would have to
shrink only 20 per cent before the liabilities would equal the assets. When the liabilities exceed the
assets, the company is said to be insolvent. Therefore, creditors are safer in Case 1 and will more
readily lend money to the company.
However, if funds borrowed at 10 per cent are used to produce earnings at a 20 per cent rate, Case 2
is preferable in terms of profitability. Therefore, owners are better off in Case 2 if the borrowed funds
can earn more than they cost.
Next, we examine the recent equity ratios of some actual companies:
Name of Company | Stockholders' Equity ($ millions) | Total Equities ($ millions) | Equity Ratio |
---|---|---|---|
Johnson & Johnson | $ 23,734 | $ 37,053 | 64.1% |
3M Corporation | 6,166 | 15,205 | 40.6 |
General Electric Company | 53,597 | 460,097 | 11.6 |
As you can see from the preceding data, the equity ratios of actual companies vary widely.
Companies such as Johnson & Johnson and 3M Corporation employ a higher proportion of
stockholders' equity (a lower proportion of debt) than GE in an effort to have stronger balance sheets
(more solvency). GE employs a greater proportion of debt, possibly in an attempt to increase
profitability. Every company must strike a balance between solvency and profitability to ensure long-
run survival. The correct balance between proportions of stockholder and creditor equities depends on
the industry, general business conditions, and management philosophy.
Chapter 1 has introduced two important components of the accounting process - the accounting
equation and the business transaction. In Chapter 2, you learn about debits and credits and how
accountants use them in recording transactions. Understanding how data are accumulated, classified,
and reported in financial statements helps you understand how to use financial statement data in
making decisions.
An accounting perspective: Uses of technology
When you apply for your first job after graduation, prospective employers will expect
you to know how to use a PC to perform many tasks. Therefore, before you graduate
you should be able to use word processing, spreadsheet, and database software. You
should be able to use the Internet to find useful information. In many universities, you
can learn these skills in courses taken for credit. If your school does not offer credit
courses, take noncredit courses or attend a training center.