When you try to find out how much of a company’s total assets are financed by shareholders’ funds rather than external debt, what do you check? Keep reading to find out more about the proprietary ratio.
This can be checked with a simple financial metric. A proprietary ratio might be the key for evaluating a business’s financial stability and solvency. Be it a company’s reliance on equity versus borrowed capital, or just non-negotiable information for investors, creditors and financial analysts.
What is the Proprietary Ratio?
The proprietary ratio, also known as the equity ratio, is a financial metric that measures a company’s equity as a percentage of its total assets. A high proprietary ratio indicates that a company is primarily financed through equity. This reduces its dependence on external debt. On the other hand, a low proprietary ratio suggests that the company relies heavily on borrowed funds, which can increase financial risk.
Formula for Proprietary Ratio
The proprietary ratio is calculated as:
Proprietary ratio = Proprietor’s funds / Total assets
where:
Proprietors’ Funds = Equity Share Capital + Preference Share Capital + Reserves and Surplus (excluding fictitious assets) + Money received against share warrants.
Total Assets = Current Assets + Non-Current Assets (including deferred revenue expenses).
For example, if a company has proprietors’ funds of ₹50 lakh and total assets of ₹1 crore, the proprietary ratio would be:
Proprietary ratio = ₹50 lakh / ₹1 crore = 0.5 or 50%
This means that 50% of the company’s assets are financed through shareholders’ equity. Hence, a balanced financial structure.
Why is this ratio important?
1. Financial Stability
A high proprietary ratio signifies that a company has a strong capital base with lower dependence on external debt. This enhances financial resilience, ensuring that the company can withstand economic downturns and market fluctuations without excessive reliance on borrowings. Investors and analysts view a high proprietary ratio as a sign of financial strength.
2. Creditworthiness
Companies with a high proprietary ratio are perceived as low-risk by lenders, making it easier for them to secure loans at favorable interest rates. Since these companies rely less on borrowed capital, they are considered safer investments by financial institutions.
3. Solvency Assessment
The proprietary ratio helps evaluate a company’s ability to meet its long-term obligations. A firm with a strong proprietary ratio is in a better position to cover its liabilities, making it more attractive to investors and creditors who seek financial security in their dealings.
4. Risk Indicator
A lower proprietary ratio implies that the company is highly leveraged, meaning it depends significantly on borrowed capital. This increases interest costs and financial liabilities, making the business vulnerable to market fluctuations. If the proprietary ratio is too low, it raises concerns about the company’s ability to sustain itself during adverse economic conditions.
How do we interpret this ratio?
High Proprietary Ratio (i.e., any ratio above 50%)
A high proprietary ratio (above 50%) indicates that the company is majorly funded by equity. This is a positive indicator as it reduces the risk of insolvency and enhances financial stability. However, an extremely high proprietary ratio might suggest that the company is underutilizing debt, which could limit its expansion potential.
Low Proprietary Ratio (i.e., any ratio below 50%)
A low proprietary ratio (below 50%) suggests a heavy dependence on external funds. This increases financial risk due to higher interest obligations. While leveraging debt is common for business growth, excessive reliance can make the company vulnerable during economic downturns.
Example
Consider two companies, A and B:
| Company | Proprietors' Funds (₹) | Total Assets (₹) | Proprietary Ratio |
|---|---|---|---|
| A | 30,00,000 | 60,00,000 | 50% |
| B | 20,00,000 | 80,00,000 | 25% |
Company A has a proprietary ratio of 50%. This indicates a balanced mix of equity and debt. Company B, with a proprietary ratio of 25%. This proves that the business relies heavily on external borrowings, hence increasing financial risk.
The ideal proprietary ratio varies by industry. For capital-intensive industries like manufacturing, a lower ratio is common due to high infrastructure costs financed through debt. Conversely, service-based companies usually maintain a higher proprietary ratio as they rely more on equity financing.
Advantages of a High Proprietary Ratio
1. Lower Financial Risk
Companies with a high proprietary ratio rely more on shareholders’ funds than on external borrowings. This means they are less burdened by interest payments and have greater financial flexibility. With lower debt, companies can better withstand economic downturns, unexpected expenses, or revenue shortfalls without falling into financial distress.
2. Better Credit Rating
A higher proprietary ratio is an attractive feature for lenders and credit agencies. It signals that a company is financially stable and capable of managing its obligations. As a result, companies with a high proprietary ratio can secure loans at lower interest rates, benefiting from reduced financing costs and better access to capital when needed.
3. Higher Investor Confidence
Investors tend to favor businesses that maintain a high proprietary ratio because it demonstrates strong financial health and self-sufficiency. A company with significant shareholder equity appears less risky and more capable of delivering consistent returns. Additionally, a lower reliance on external debt ensures that profits are not heavily eroded by interest expenses, increasing potential earnings for investors.
Disadvantages of a Low Proprietary Ratio
1. High Dependency on Debt
A low proprietary ratio indicates that a company finances a significant portion of its assets using external borrowings. While leveraging debt can fuel expansion, excessive reliance on borrowed funds increases financial obligations, making it harder to manage repayments, especially during economic downturns or business slowdowns.
2. Higher Risk of Bankruptcy
Companies with a low proprietary ratio face a greater risk of insolvency, as their high debt levels make them vulnerable to financial instability. If revenue declines or interest rates rise, such businesses may struggle to meet their debt repayments, leading to liquidity crises or potential bankruptcy.
3. Reduced Credibility with Investors and Lenders
Investors and financial institutions often perceive companies with low proprietary ratios as risky. Such firms may find it difficult to attract new investors or secure favorable loan terms, as creditors may be wary of extending further financial support due to the increased risk of default.
Limitations of the Proprietary Ratio
While the proprietary ratio is a valuable financial metric, it should not be used in isolation. There are several limitations to consider:
1. Excludes Profitability and Cash Flow
The proprietary ratio does not account for a company’s ability to generate profits or maintain steady cash flow. A company with a high proprietary ratio but weak cash flow may still struggle to meet operational expenses.
2. Industry Variations
Different industries have varying capital structures. Capital-intensive businesses, such as manufacturing and infrastructure firms, often require substantial external funding, resulting in lower proprietary ratios. On the other hand, service-based companies may operate efficiently with higher proprietary ratios.
3. Limited Insight into Financial Health
While the proprietary ratio helps assess solvency, it does not provide a complete picture of a company’s financial standing. Other metrics, such as the return on equity (ROE), debt-to-equity ratio, and current ratio, should be analyzed alongside the proprietary ratio for a more comprehensive evaluation of financial health.
Wrapping Up
So, when you think of a company’s financial stability and solvency, you check its proprietary ratio. A high proprietary ratio indicates reduced reliance on external debt. Meanwhile, a low proprietary ratio suggests increased financial risk due to high dependency on borrowed capital. However, while this ratio provides valuable insight about a company, it should be used with other financial indicators to assess a company’s financial health.
Interested in how we think about the markets?
Read more: Zen And The Art Of Investing
Watch here: Is UPI Killing the Toffee Business?
