The proprietary ratio (also known as net worth ratio or equity ratio) is used to evaluate the soundness of the capital structure of a company. It is computed by dividing the stockholders’ equity by total assets.
Some analysts prefer to exclude intangible assets (goodwill etc.) from the denominator of the above formula. In that case, the formula would be written as follows:
The information about stockholders’ equity and assets is available from balance sheet.
Al-Faisal Inc. has the following in its balance sheet as on December 31, 2021:
- Total assets: $950,000
- Intangible assets: $150,000
- Stockholder’s equity: $440,000
From the above information we can compute the proprietary ratio of Al-Faisal as follows:
(440,000 / 800,000 ) × 100
The proprietary ratio is 55%. It means stockholders’ has contributed 55% of the total tangible assets. The remaining 45% have been contributed by creditors.
Significance and interpretation:
The proprietary ratio shows the contribution of stockholders’ in total capital of the company. A high proprietary ratio, therefore, indicates a strong financial position of the company and greater security for creditors. A low ratio indicates that the company is already heavily depending on debts for its operations. A large portion of debts in the total capital may reduce creditors interest, increase interest expenses and also the risk of bankruptcy.
Having a very high proprietary ratio does not always mean that the company has an ideal capital structure. A company with a very high proprietary ratio may not be taking full advantage of debt financing for its operations that is also not a good sign for the stockholders.