Equity is the percentage of a company that is owned by investors. It is often made up of common stock, preferred stock, and bonds. The asset/equity ratio reveals the percentage of a company's assets that are financed by equity. A high percentage can reveal an unhealthy situation and the company's inability to fulfill its obligations to stockholders. Some of the best methods to improve an asset/equity ratio are to reduce debt and increase the value of a company's assets.
One of the ways to improve the asset/equity ratio is to increase the value of a company's assets. This can be accomplished by achieving a higher amount of sales and net profit. Even an increase in the amount of inventory a firm keeps on hand will improve the asset/equity ratio as long as the firm purchases it with its own cash. Long-term assets might also improve the ratio as long as the purchases are not heavily financed.
A higher sales volume can increase current assets when a company decides to maintain a high cash balance or reinvest profit into capital equipment. Assets contribute to a firm's liquidity and ability to pay off debt. Current assets can usually be converted to cash more quickly than long-term assets. For example, inventory that a company stores in a warehouse might be sold within a few weeks, whereas a building might take a year or more to sell.
The ratio could also be improved by decreasing the amount of equity or liabilities owed to investors. Since bonds are sometimes viewed as a less desirable form of equity, some firms will limit the amount of bonds they issue. Stock splits are another method to increase the amount of shares while lowering the amount owed per share. In a stock split, the number of potential investors increases, but the total liability amount remains steady.
Companies often issue bonds and stocks in order to raise capital. Investors exchange cash for a claim against the company's assets and earnings. The claim must be paid in the event the investor sells his shares or bonds. Equity is considered to be a liability from the company's accounting perspective since it is essentially future money owned to investors.
Each industry has an asset/equity ratio average. For example, the restaurant industry might have a standard ratio of 50 percent, while the consumer goods manufacturing industry might have an average ratio of 75 percent. Most firms compare their individual asset/equity ratio to their industry's as a benchmark. In order to improve the ratio, an increase in assets or a decrease in equity is needed.