What it means
The underlying principle is old fashioned but sound: long term assets should be funded by long term finance. Buying a $2,000,000 machine with an overdraft that the bank can withdraw at any time is asking for trouble, and this ratio is one way of checking that mismatch has not happened.
It is used most in asset heavy sectors such as manufacturing, transport, hospitality and agriculture, where fixed assets dominate the balance sheet. In a consultancy or software business, where most value sits in people and intangibles, the ratio carries far less meaning.
A ratio above 1.0 means equity alone covers all the fixed assets, with money left over to fund stock and receivables, which is a conservative and comfortable position. A ratio well below 1.0 means substantial borrowing sits behind the property and plant, so lenders will want to see what security they hold and how the loans are being repaid.
Interpretation depends on what those loans look like. Fixed assets funded by a fifteen year mortgage on a freehold site is normal and often sensible, while the same assets funded by short term facilities is a genuine warning sign about liquidity.
One practical caution is that fixed assets are carried at cost less accumulated depreciation, which can be far from their market value. An old factory written down to almost nothing in the books may be worth a great deal, and a specialised production line may be worth far less than its carrying value.
In practice
Real-world examples.
Example
A haulage business shows a ratio of 0.45 because most of its fleet is funded by hire purchase agreements. The finance director is comfortable, since each agreement is matched to the expected life of the vehicle it funded.
Example
A boutique hotel group buys a second property using a short term bridging loan, expecting to refinance within months. The ratio falls to 0.3 and the auditors raise the funding mismatch in their management letter, prompting an early move to a fifteen year facility.
Example
A ceramics manufacturer sells and leases back its main site, which removes the building from fixed assets and boosts the ratio from 0.7 to 1.1. The improvement is real on paper, but the company has traded ownership for a long term rent commitment that does not appear in the calculation.
Think of it
“Equity to fixed assets shows if shareholders' investment covers your long-term physical assets.
Formula
Calculation
Equity to fixed assets ratio = total shareholders' equity / net fixed assets
A food processing company owns a factory, cold storage and production lines with a net book value of $30,000,000 after accumulated depreciation. Shareholders' equity on the same balance sheet is $24,000,000.
The ratio = $24,000,000 / $30,000,000 = 0.80. Owners have funded 80% of the fixed assets, and the remaining $30,000,000 - $24,000,000 = $6,000,000 must come from borrowings or other long term funding. If the company then raises $12,000,000 in a share issue and holds the cash, equity rises to $24,000,000 + $12,000,000 = $36,000,000 while net fixed assets stay at $30,000,000, lifting the ratio to $36,000,000 / $30,000,000 = 1.20. At that point equity covers every fixed asset with $6,000,000 to spare for working capital.Case study
Seen in the real world.
The following is an illustrative and fictional example. Thornbury Mills, an invented flour milling company, expanded by buying two additional sites for a combined $18,000,000 and funded most of the cost on a revolving credit facility because the rate was attractive and the paperwork was quick. Its equity to fixed assets ratio fell from 0.95 to 0.52 in a single year.
The facility was renewable annually at the bank's discretion. When the bank reviewed its exposure to food processing after two industry failures, it declined to renew the full amount and offered only half, giving Thornbury ninety days to find $9,000,000.
In this fictional illustration the company survived by arranging a mortgage secured on the freehold sites at a rate almost two percentage points higher than the facility it had been enjoying. The extra interest cost roughly $180,000 a year, a straightforward price for having funded fifteen year assets with one year money.
Watch out
Common mistakes.
- Reading a low ratio as automatic bad news, when long term debt properly matched to asset lives is a perfectly sensible way to fund plant and property.
- Applying the ratio to service or software businesses, where fixed assets are small and the result swings wildly on trivial changes.
- Forgetting that net book value is a historic cost figure, so a fully depreciated but valuable building makes the ratio look better than economic reality.
Questions
People also ask.
What is a good target for this ratio?
For most asset heavy manufacturers something between 0.6 and 1.0 is comfortable, provided any borrowing behind the fixed assets is genuinely long term.
How is this different from the equity to asset ratio?
The equity to asset ratio compares equity with everything the company owns, while this version looks only at long lived physical assets and therefore focuses on funding mismatch.
Does leasing equipment change the ratio?
Yes, and in both directions, since leases recognised on the balance sheet add to assets while an old style off balance sheet arrangement would keep the asset out of the calculation entirely.
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