What it means
Shareholders' equity is the money the owners have put in plus all the profit the business has retained over its life, and it represents the shareholders' stake in the assets. Dividing sales by that figure shows how much trading volume each dollar of owner capital generates, which is why the ratio is sometimes called equity turnover.
It sits alongside return on equity as a way of judging whether owner money is being put to good use. The ratio matters because equity is the most expensive money a business can use.
Shareholders expect a higher return than lenders do, so capital sitting in a business that generates little trading activity is an expensive form of idleness. A rising ratio generally means the same owner investment is supporting more business.
The essential caution is that a high ratio can come from strength or from weakness. A company can achieve a high sales to equity ratio through genuine efficiency, or simply by having very little equity because it is heavily funded by debt.
The ratio therefore always needs reading next to the debt to equity ratio, or the picture will be misleading. The measure is also distorted by accounting history.
A long established manufacturer that has retained decades of profit will show a large equity base and a lower ratio than a younger competitor of the same size, without being any less efficient. Buybacks, large dividends and accumulated losses all shrink equity and flatter the ratio for reasons that have nothing to do with operations.
Used carefully, it is most valuable as a trend and as a component of a wider analysis. Breaking return on equity into margin, asset turnover and financial leverage shows exactly where this ratio fits, since equity turnover captures the sales generating half of that picture.
In practice
Real-world examples.
Example
A recruitment firm with $6,000,000 of sales and $1,000,000 of equity shows a ratio of 6.0, which is normal for a people business that needs almost no capital equipment to trade.
Example
A property investment company shows a ratio of 0.4 because it holds a large asset base funded by shareholder capital against modest rental income. Comparing it with a service business on this measure would tell you nothing useful.
Example
A family manufacturer that has retained profit for thirty years sees its ratio drift down from 4.0 to 1.8 as cash accumulates on the balance sheet. The board responds with a special dividend, which reduces equity and lifts the ratio without changing the underlying trading at all.
Think of it
“Sales to equity shows how much revenue your shareholders' investment generates.
Formula
Calculation
Sales to equity ratio = annual net sales / total shareholders' equity
A packaging manufacturer records net sales of $15,000,000 for the year. Its balance sheet shows share capital of $1,000,000 and retained earnings of $4,000,000, so total shareholders' equity is $1,000,000 + $4,000,000 = $5,000,000.
Sales to equity ratio = $15,000,000 / $5,000,000 = 3.0.
A competitor with the same $15,000,000 of sales but $7,500,000 of equity shows $15,000,000 / $7,500,000 = 2.0. Before concluding the first company is the better operator, an analyst would check its borrowings, because the smaller equity base may simply mean it is funded with more debt and therefore carries more risk.Case study
Seen in the real world.
The following is a fictional, illustrative example. Brightmoor Fixtures, an invented lighting manufacturer, was compared by its new chair against a listed rival on a sales to equity basis. Brightmoor showed 1.6 against the rival's 4.2, and the first reaction in the boardroom was that the company must be badly run.
The finance director set out the reason. Brightmoor had never paid a dividend in eighteen years and held $9,000,000 of retained earnings against $14,400,000 of sales, while the rival had bought back shares and funded itself heavily with debt, leaving a much thinner equity base.
In this illustrative case the board concluded that the ratio had identified a capital allocation question rather than an operating problem. Brightmoor released $3,000,000 through a one off dividend and a factory upgrade, lifting the ratio to roughly 2.4 while keeping borrowings at a level the directors were comfortable defending.
Watch out
Common mistakes.
- Treating a high sales to equity ratio as proof of efficiency without checking whether it is caused by heavy borrowing rather than good management.
- Comparing capital intensive businesses such as property or utilities against service firms, where the normal ratios are worlds apart.
- Using a year end equity figure straight after a large dividend or share buyback, which artificially inflates the result.
Questions
People also ask.
Is this the same as return on equity?
No, return on equity divides profit by equity, while this ratio divides sales by equity and says nothing about whether those sales are profitable.
Can the ratio be negative?
Yes, if accumulated losses have pushed equity below zero, in which case the ratio is meaningless and the balance sheet needs attention instead.
Should average or closing equity be used?
Average equity across the year is more accurate, especially where profits, dividends or new share issues have moved the balance significantly.
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