What it means
The starting point is reported shareholders' equity, which is what the accounts say the owners have in the business. The adjustment step removes items that would not convert into cash or absorb losses when needed, typically goodwill and other intangibles, certain deferred tax assets, holdings in other financial institutions and sometimes pension surpluses.
What remains is the capital an analyst believes is really there. The denominator is adjusted too, so that risk rather than size drives the comparison.
Assets are weighted by how likely they are to lose value, so cash and government bonds carry a light weight while unsecured lending carries a full one. Two lenders with identical total assets can therefore show very different ratios.
Banks, insurers and finance companies are the natural home for this measure, because their regulators set minimum capital levels and because their failure spreads to others. Ratings agencies and lenders also run their own versions, so a company may quote one ratio while a counterparty quotes another.
The definitions differ, which makes asking which adjustments are included the first sensible question. For a non financial business the same thinking appears as tangible net worth or adjusted net worth in loan covenants.
A bank lending to a manufacturer may require tangible equity above a stated figure, which strips goodwill out of the test in exactly the same way. Breaching that covenant can trigger early repayment even when reported equity still looks healthy.
The main nuance is that a higher ratio is not automatically better for shareholders. Capital held is capital not working, so the sensible target is comfortably above the regulatory or covenant minimum rather than as high as it can possibly go.
In practice
Real-world examples.
Example
A credit analyst comparing two consumer lenders finds that both report equity worth 11% of total assets. After removing goodwill and unusable deferred tax assets, one falls to 9% and the other to 6%, and the weaker lender is priced accordingly on its next bond issue.
Example
A regional insurer plans a $40,000,000 acquisition funded largely by goodwill. The finance team models the effect and finds the adjusted capital ratio dropping from 9% to 7%, so it funds part of the deal with fresh equity to stay above its internal floor.
Example
A manufacturer's loan agreement requires tangible net worth of at least $25,000,000. A write down of $6,000,000 of intangibles cuts the tested figure to $24,000,000 and puts the company in technical breach, so the treasurer negotiates a covenant reset before the quarter closes.
Formula
Calculation
Adjusted capital ratio = adjusted capital / risk weighted assets
Adjusted capital = reported equity - goodwill and intangibles - disallowed deferred tax assets - other deductions
Worked example: a mid sized lender reports equity of $120,000,000. It carries $15,000,000 of goodwill from an earlier acquisition and $5,000,000 of deferred tax assets that its lenders refuse to count, so adjusted capital is 120,000,000 - 15,000,000 - 5,000,000 = $100,000,000. Its risk weighted assets total $1,250,000,000. The adjusted capital ratio is 100,000,000 / 1,250,000,000 = 0.08, or 8%. If the regulator requires 6%, the minimum capital needed is 0.06 x 1,250,000,000 = $75,000,000, so the lender has $25,000,000 of headroom.Case study
Seen in the real world.
Stonebridge Finance is an illustrative, fictional lender to small builders that grew by buying three rival loan books in five years. Reported equity stood at $180,000,000 against risk weighted assets of $1,500,000,000, which looked like a comfortable 12%.
A new lender running its own test deducted $62,000,000 of goodwill and $8,000,000 of deferred tax assets, leaving adjusted capital of $110,000,000 and a ratio of 110,000,000 / 1,500,000,000 = 7.3%. That was above the regulatory minimum but below the 9% floor the lender required in its facility agreement, and the funding line was reduced.
In this fictional sequence Stonebridge had not lost money or broken a rule; it had simply paid for growth with acquisitions and recorded much of the price as goodwill. It raised $40,000,000 of new equity, which lifted the adjusted ratio to 10%, and from then on it modelled every acquisition on an adjusted basis before signing.
Watch out
Common mistakes.
- Comparing adjusted capital ratios from two sources without checking that the same deductions and risk weights were used in both.
- Reading reported equity as loss absorbing capital when a large part of it is goodwill from past acquisitions.
- Assuming the highest possible ratio is the goal, which ties up capital that could be earning a return for shareholders.
Questions
People also ask.
Why adjust capital at all?
Because some balance sheet items cannot be sold or used to pay creditors when a business is under stress, so counting them overstates real strength.
Is this the same as the capital adequacy ratio?
They are close cousins, but a capital adequacy ratio follows the regulator's prescribed definition while adjusted versions reflect an analyst's or lender's own deductions.
What does a falling ratio signal?
Usually that risk weighted assets are growing faster than capital, through rapid lending growth, acquisitions or losses eroding equity.
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