Equity Ratio

What is the equity ratio?

Equity ratio (German: Eigenkapitalquote) denotes the share of equity in a company's total capital, calculated as equity divided by total assets times 100. Total assets (Bilanzsumme) are the sum of all assets and always equal the sum of equity and debt capital. The ratio shows the extent to which assets are financed with shareholders' funds rather than with creditors' funds. It thus also shows how much loss a company can absorb before creditors are affected.

Formula: Equity ratio = equity / total assets × 100%

If a workshop building costing EUR 1 million is paid for with EUR 300,000 of own funds and EUR 700,000 through a bank loan, the equity ratio of this financing is 30%.

The key figure belongs to the balance sheet analysis of banks, credit insurers and suppliers. It appears as a financial covenant in loan agreements and is among the first values that investors and buyers review in a financial due diligence, the examination of the financial figures before the contract is signed. The basis is the equity shown in the balance sheet; banks additionally work with an economically adjusted value.

Calculating the equity ratio: equity under the HGB

For corporations, Section 266(3) of the German Commercial Code (Handelsgesetzbuch, HGB) divides equity into five items:

• Subscribed capital: for a GmbH (German limited liability company), the share capital (Stammkapital), that is, the nominal amount of the capital fixed in the articles of association and entered in the commercial register. Contributions that the company has not yet called in are openly deducted from it.
• Capital reserve: above all the premium and other additional payments by the shareholders into equity (Section 272(2) HGB). The premium is the amount that investors pay above the nominal amount when new shares are issued. In funding rounds, by far the largest part of the investment flows here, because investors usually take up new shares at the nominal amount and make the rest as a premium or contractually agreed additional payment.
• Revenue reserves: retained profits of earlier years, for example on the basis of the articles of association or a shareholders' resolution.
• Profit carried forward or loss carried forward: the result of previous years not yet appropriated.
• Net income or net loss for the year: the result of the current financial year.

Shareholder loans do not belong to balance sheet equity, even if they carry a subordination agreement (Rangrücktritt). With a subordination agreement, the shareholder declares that, in the worst case, the shareholder will be paid only after all other creditors. The loan nevertheless remains a liability.

Negative equity and over-indebtedness

If accumulated losses exceed existing equity, it becomes arithmetically negative. The HGB then does not show the amount as negative equity on the liabilities side but at the end of the assets side as “deficit not covered by equity” (Section 268(3) HGB). An equity ratio can no longer be meaningfully stated in this state.

Such a deficit means balance sheet over-indebtedness. It is not to be equated with over-indebtedness under Section 19 of the German Insolvency Code (Insolvenzordnung, InsO). That exists only if assets no longer cover existing liabilities and the continuation of the company over the next twelve months is not predominantly probable. The assessment of this is called the going-concern forecast; if it is positive, there is no over-indebtedness within the meaning of the InsO. Shareholder loans with a qualified subordination agreement remain disregarded in the over-indebtedness test (Section 19(2) sentence 2 InsO). For the management, a balance sheet deficit is a reason to examine the duty to file under Section 15a InsO and to document the going-concern forecast, ideally supported by ongoing early crisis detection.

Loss of half of the share capital

A duty under company law applies even earlier. If it emerges from the annual balance sheet or an interim balance sheet that half of the share capital has been lost, the management must convene a shareholders' meeting without undue delay (Section 49(3) of the German Limited Liability Companies Act (GmbHG)). If it omits to notify the shareholders of the loss, this is a criminal offence under Section 84 GmbHG. According to a widespread view, what matters is whether balance sheet equity has fallen below half of the share capital; reserves therefore absorb losses first. With high capital reserves, the threshold is therefore reached only late, but then shortly before equity is fully consumed.

Economic equity ratio from the banks' point of view

Banks do not assess the equity base on the balance sheet alone. For the credit decision, they form an economic equity, the calculation of which differs from institution to institution. Shareholder loans with a subordination agreement are often added, to the extent that they remain in the company for the long term. Mezzanine capital with equity character is added as well, a hybrid of equity and debt such as subordinated loans or silent partnerships. Items whose recoverability is doubtful in a crisis are often deducted, for example capitalised internally generated intangible assets, goodwill or receivables from shareholders.

The result feeds into the rating and thus into the credit commitment, interest rate and collateral (creditworthiness). In loan agreements, a minimum equity ratio is often agreed as a financial covenant whose compliance the bank monitors continuously (Covenants). The contract then specifies which items are added and deducted. If this definition deviates from the annual financial statements, the ratio must be calculated separately for each report to the bank.

Equity ratio of venture-financed companies

Venture capital is equity capital that investors provide to young growth companies in return for shares. For companies financed in this way through funding rounds, the equity ratio follows a typical course. Immediately after a round, it is high, because the investors' payments flow into the capital reserve and are held as bank balances on the assets side. With every month of loss, the loss carried forward and the net loss for the year economically consume the capital reserve; equity and total assets fall at the same time, and the ratio falls.

A high equity ratio at these companies is therefore not a sign of earning power but an expression of the funds most recently raised. More meaningful is the point at which equity would turn negative without new funds. It is directly linked to the runway, the number of months for which the existing funds last, and thus to the planning of the next round. Whether the threshold of Section 49(3) GmbHG was reached in the past and the associated duties were complied with is likewise among the review points of the due diligence.

Worked example: equity ratio of a venture-financed GmbH

A venture-financed GmbH reports the following equity at the balance sheet date (amounts in thousands of euros): subscribed capital 60, capital reserve 12,000, loss carried forward minus 7,500, net loss for the year minus 2,400. Total assets amount to 4,800. The liabilities include a shareholder loan of 480 with a qualified subordination agreement, that is, ranking behind all other creditors.

• Balance sheet equity: 60 plus 12,000 minus 7,500 minus 2,400 = 2,160
• Equity ratio: 2,160 / 4,800 = 45%
• Economic equity including shareholder loan: 2,160 plus 480 = 2,640
• Economic equity ratio with unchanged total assets: 2,640 / 4,800 = 55%
• Following year with the same loss and no new funds: 2,160 minus 2,400 = minus 240, to be shown as a deficit not covered by equity
• Threshold under Section 49(3) GmbHG: half of the share capital = 30
• Loss per month with an even course: 2,400 / 12 = 200; the threshold is breached after (2,160 minus 30) / 200 = just under eleven months
• Complete consumption of equity: 2,160 / 200 = 10.8 months

Despite a ratio of 45% at the balance sheet date, the company is less than eleven months away from balance sheet over-indebtedness. Arithmetically, the duty to notify the loss arises only a few days before that, because the high capital reserve absorbs the losses at first. In the over-indebtedness test under Section 19 InsO, the subordinated loan would remain disregarded and would arithmetically provide a buffer of 480. What is decisive, however, is the going-concern forecast and thus the question of whether the next funding round is secured in time.

Distinctions: equity ratio, debt ratio and share capital

• Debt ratio: in its static form relates debt capital to equity instead of to total assets. With the same delineation, the two key figures can be converted into each other: an equity ratio of 25% corresponds to a debt ratio of 3.0.
• Return on equity: measures the return on equity, not its share in the financing. A low equity ratio can raise profitability but at the same time raises risk.
• Share capital: the nominal amount fixed in the articles of association, at least EUR 25,000 for a GmbH (Section 5(1) GmbHG), and only one component of equity.
• Equity share in a property purchase: in private construction financing, equity ratio means the share of own funds in the purchase price and ancillary costs. That is a ratio for an individual project, not a key figure from the balance sheet.

Common mistakes

• Subordination confused with equity. A shareholder loan with a subordination agreement improves the over-indebtedness test and the bank's view, but not balance sheet equity.
• Balance sheet and insolvency-law over-indebtedness equated. A deficit in the balance sheet does not in itself trigger a duty to file but requires a reliable going-concern forecast.
• Notification of loss overlooked. The duty to convene under Section 49(3) GmbHG also applies during the year and is easily missed without reliable monthly financial statements.
• Ratio at the balance sheet date without trend. For companies with ongoing losses, the ratio at the balance sheet date says little; what matters is how long equity remains positive at the current trend.
• Contractual definition ignored. Anyone who reads the agreed ratio from the annual financial statements instead of applying the adjustments of the loan agreement may report an incorrect value to the bank.

Frequently asked questions

What is a good equity ratio?

There is no fixed benchmark. As a rough rule of thumb, a ratio from about 20% is considered sound, from about 30% good and below 10% weak. How much equity is appropriate depends on how strongly results fluctuate and how well the assets serve as collateral. A higher ratio improves rating and credit scope. For growth companies with ongoing losses, banks attach more weight to liquidity and the investor base than to the ratio.

How can the equity ratio be increased?

By more equity or a shorter balance sheet. More equity arises from retained profits, a capital increase or additional payments by the shareholders into the capital reserve. The balance sheet becomes shorter when the company repays debt with available liquid funds. A shareholder loan counts as balance sheet equity only once the shareholder waives it and the amount goes into the capital reserve; the tax consequences depend on how recoverable the loan is.

Does an equity ratio of 100% make sense?

Rarely. A company without any debt capital forgoes cheaper sources of financing and the leverage effect on return on equity. In any case, practically every company reports provisions and trade payables, so the ratio is below 100%.

Do convertible loans count as equity?

Not on the balance sheet as long as they have not been converted. A convertible loan is a liability until conversion; if it carries a qualified subordination agreement, banks often count it as economic equity. On conversion, the amount is rebooked into subscribed capital and capital reserve.

How does a funding round affect the equity ratio?

It raises the ratio immediately. The amount paid in raises equity and bank balances equally, so that the equity share in the increased total assets grows. How long the effect lasts is determined by the loss rate of the following months.

The Roemer Capital view

From the plan and monthly financial statements, Roemer Capital calculates before a funding round when equity would reach the threshold of Section 49(3) GmbHG without new funds and when it would be consumed. These points in time determine the lead time needed: with a process duration of 6 to 8 months, the round must start well before these thresholds.

Where bridge financings with subordination or the going-concern forecast play a role, Roemer Capital supplies the planning calculation; the legal assessment is taken on by the client's law firm and tax adviser. Towards banks, Roemer Capital explains how balance sheet and economic equity differ and why a ratio at the balance sheet date describes the financing position of a growing company only incompletely.