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Sales to Equity Ratio Definition

Definition

The earnings to equity percentage is a asset usage metric which allows individuals to understand that the sum of equity a provider requires to encourage a given degree of earnings. Investor-analysts routinely track this ratio as time passes, as it will remain relatively constant as earnings revenues grow.

Calculation

Sales to Equity Ratio = Net Sales / Total Equity

Where:

  • Net Sales = Gross Sales – Returns
  • Total Equity: comprises capital stock, paid-in funding over par, in addition to retained earnings, which might be the percentage of earnings not distributed to investors in the kind of dividends.

Explanation

Asset usage measures make it possible for investor-analysts to comprehend how a company uses its resources in surgeries. The definition of “assets” identifies the investors ‘ monies when examining the sales to equity ratio. This metric is typically tracked over time, and must be evaluated along with other metrics such as fixed assets (property, plant, equipment).

As a company grows, their need for working capital increases, which is the difference between current assets and current liabilities. This money allows the company to pay its debts as they come due. For example, a higher level of sales requires more inventory; more people to make, sell, fulfill and support orders; and more raw materials to support an increase in production. To ensure a company can meet these short term obligations, they need to increase the level of liquid assets they’re holding such as cash.

As companies increase net sales, they should also be generating higher levels of net income too. This money can be distributed back to shareholders in the form of dividends, or held by the company as retained earnings, which increases total equity. The sales to equity ratio can be used to measure the relationship between an increase in sales and the amount of equity provided by shareholders.

Keep in mind that as a company grows, it may also require additional fixed assets such as property, plant and equipment. It may also decide to issue new shares of stock or debt (leverage). That’s why the sales to equity ratio must be evaluated along with additional operating and financial metrics.

Example

The CFO of Company A asked her staff to evaluate the opportunity to increase the company’s dividend. Company A had been experiencing growth in sales over the last several years, and is forecasting that trend to continue for at least three more years. The finance team’s initial screening criteria included an evaluation of Company A’s sales to equity ratio as illustrated in the table below:

Year 0 Year 1 Year 2 Year 3
Sales $200,000,000 $220,000,000 $242,000,000 $266,200,000
Retained Earnings $30,500,000 $33,500,000 $36,800,000 $40,430,000
Paid-in Capital $50,000,000 $50,000,000 $50,000,000 $50,000,000
Total Equity $80,500,000 $83,500,000 $86,800,000 $90,430,000
Sales to Equity Ratio 2.48:1 2.63:1 2.79:1 2.94:1
Property, Plant, Equipment $30,000,000 $33,000,000 $36,300,000 $39,930,000

The team discovered the ratio was growing over time, driven by an increase in retained earnings of roughly $3,000,000 per year. The team also noticed the investment in property, plant and equipment was growing at nearly the same rate. Since Company A did not plan to issue more debt in the next three years, the CFO’s team concluded the growth in retained earnings was needed to fuel the company’s sales growth, and the dividend policy should remain constant over this planning period.