Financial Systems

Appropriate Level of Equity

 
What does Appropriate Level of Equity mean?

An appropriate level of equity means having a business that has sufficient level of capital and does not have too much or too little equity.

 

Problems with Too Little Equity

If a business has too little equity, then it can experience problems it terms of having insufficient capital to expand or invest. A business may not have the capital it requires to invest in new technologies, plant and equipment or property it needs to maintain or expand its market share with other competitors.

 

 

Problems with Too Much Equity

If a business has too much equity than it can become difficult to maintain dividend payouts to shareholders or investors. For example, consider a company with a profit of $10 million who has 10 million shareholders. If all the profit was paid to shareholders, the dividend will be $1 per share. If there was an additional share issue, increasing the volume of shareholders to 20 million, then the dividend payout will decrease to 50 cents per share unless the profit increases to $20 million.

 

If shareholders are unsatisfied with reduced dividend payouts, then it could result in lower demand for the company's shares, decreasing the company's value.

 

Gearing Ratio - Debt to Equity Ratio

The debt to equity ratio is one indicator that can be used to assess the level of equity. The debt to equity ratio measures the total liabilities of a company to the total equity of a company.

 

Highly Geared

A business is deemed highly geared if its debt to equity ratios are significantly higher than the market average and often above 200%. A highly geared company suggests a business has too much debt relative to its equity and there is an increased risk in obtaining shares in the company.

 

Lowly Geared

A business is deemed lowly geared if its debt to equity ratios are below market averages and often below 100%. A lowly geared company suggests the business has a low amount of debt relative to equity and has an appropriate level of equity and is a relatively safe investment.

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