{"id":1213,"date":"2024-02-09T08:43:21","date_gmt":"2024-02-09T07:43:21","guid":{"rendered":"https:\/\/creditanalyst.eu\/?p=1213"},"modified":"2024-02-09T08:43:23","modified_gmt":"2024-02-09T07:43:23","slug":"what-is-wrong-with-the-equity-ratio-2-myths-about-equity-ratio-and-its-quality","status":"publish","type":"post","link":"https:\/\/kurtovicfinancial.com\/en\/what-is-wrong-with-the-equity-ratio-2-myths-about-equity-ratio-and-its-quality\/","title":{"rendered":"WHAT IS WRONG WITH THE EQUITY RATIO? 2 myths about Equity ratio and its quality"},"content":{"rendered":"\n

Equity ratio is often used to assess a company\u2019s financial strength, and it is often used as a financial covenant in loan agreements, so it is extremely important what it really means.<\/p>\n\n\n\n

\"\"<\/figure>\n\n\n\n

Myth 1 \u2013 High equity ratio confirms company\u2019s financial strength.<\/strong><\/p>\n\n\n\n

Many think that high Equity ratio normally means there is a huge amount of money parked in company\u2019s assets.<\/p>\n\n\n\n

But that does not have to be true.<\/p>\n\n\n\n

Money can be invested in assets which are not of much value<\/strong> \u2013 doubtful receivables, obsolete inventories, goodwill, or outdated fixed assets\u2026<\/p>\n\n\n\n

Think of the ratio\u2019s numerator and what it consists of.<\/p>\n\n\n\n

Normally the largest element of the shareholders\u2019 equity is retained earnings.<\/p>\n\n\n\n

But retained earnings are generated over time in the income statement, not cash flow.<\/strong><\/p>\n\n\n\n

That means that although profit is there, there might not be enough cash to pay it out.<\/strong><\/p>\n\n\n\n

Think also about the Equity ratio\u2019s denominator: Total assets.<\/p>\n\n\n\n

Total assets cover so many things, and that amount does not necessarily represent the actual value of company\u2019s assets.<\/strong><\/p>\n\n\n\n

Think only about how different asset valuation methodologies can be, or how some balance sheets can be inflated or undervalued.<\/p>\n\n\n\n

Myth 2 \u2013 If a company bankrupts, high equity ratio means there will be enough value to cover creditors\u2019 exposure.<\/strong><\/p>\n\n\n\n

Not necessarily.<\/p>\n\n\n\n

If a company cannot service its debt, that often means that the assets a company owns do not generate enough cash flow.<\/p>\n\n\n\n

If an asset does not generate enough cash flow \u2013 how much is it worth?<\/strong><\/p>\n\n\n\n

Don\u2019t forget that asset value drops significantly when a company bankrupts.<\/strong><\/p>\n\n\n\n

There is a reason why banks sell their NPLs often at 20% of their exposure, or even less\u2026<\/p>\n\n\n\n

This means that the Equity ratio of 30-40% of a bankrupted company normally means any shareholders\u2019 value will be wiped out\u2026<\/p>\n\n\n\n

________<\/p>\n\n\n\n

Would you be surprised if I told you that none of the rating agencies has the Equity ratio prescribed in their methodologies?<\/p>\n\n\n\n

There is no typical amount of equity which should be in a company\u2019s balance sheet.<\/p>\n\n\n\n

There is only maximum amount of debt<\/strong> which should be there.<\/p>\n\n\n\n

High amount of debt is one of the major reasons why companies bankrupt.<\/p>\n\n\n\n

So, when somebody asks you how much equity should they have \u2013 flip the question by asking \u2013 how much debt could they handle?<\/strong><\/p>\n\n\n\n

________<\/p>\n\n\n\n

CreditAnalyst(.eu) \u2013 Improving your company’s cash flow.<\/strong><\/p>\n\n\n\n

Credit Risk Management \u2022 Cash Flow Controlling \u2022 Debt Advisory \u2022 Financial Planning<\/strong><\/p>\n","protected":false},"excerpt":{"rendered":"

Equity ratio is often used to assess a company\u2019s financial strength, and it is often used as a financial covenant in loan agreements, so it is [\u2026]<\/span><\/p>\n","protected":false},"author":4,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[19,22,6],"tags":[133,225,169],"class_list":["post-1213","post","type-post","status-publish","format-standard","hentry","category-credit-guide-2","category-credit-insights","category-blog-en","tag-cash-flow","tag-equity-ratio-2","tag-financial-ratios"],"_links":{"self":[{"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/posts\/1213","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/users\/4"}],"replies":[{"embeddable":true,"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/comments?post=1213"}],"version-history":[{"count":1,"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/posts\/1213\/revisions"}],"predecessor-version":[{"id":1214,"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/posts\/1213\/revisions\/1214"}],"wp:attachment":[{"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/media?parent=1213"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/categories?post=1213"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/kurtovicfinancial.com\/en\/wp-json\/wp\/v2\/tags?post=1213"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}