A high equity ratio is always associated with a high credit rating and offers a certain buffer for times of crisis.
How is the equity ratio calculated?
As with all ratios (fraction times one hundred), “what is involved” is placed in the numerator. The numerator contains the equity capital. Equity is also the partial mass. Also typical for a ratio: The denominator contains the total mass, the total capital. This is the formula for calculating the equity ratio.
How can you increase the equity ratio?
First you will have to understand the structure of a balance sheet. A balance sheet has an asset. side and a liability side. The liabilities side shows the source of funds. The equity and the debt and both make up the total capital. The assets side shows fixed assets and current assets, and this results in the total assets. Total assets is equal to total capital (liabilities). Both values are the same, only derived from the consideration of different perspectives. On the liabilities side is the source of funds on the assets side is how the funds are used. You can only use what has come from somewhere at some point. Either it is your own money or someone else’s money. Since both sides balance each other out, it is also called the “balance sheet”. So how can you then increase the equity ratio? In the direct way you increase the equity ratio by increasing the equity value. The second way is indirect, in which the equity capital remains the same, but the borrowed capital is reduced. This also increases the equity ratio. In the case of a corporation, this is relatively easy, but in principle, a limited liability company can also increase its equity.
Here is the first possibility. The capital increase happens de facto by taking in new shareholders or existing shareholders acquire additional shares. In the case of a stock company, these are new shareholders, or existing shareholders buy additional shares. This is the direct way that brings up the value of the equity ratio.
Here is the second option (the direct route): The second way to directly increase the equity ratio is to retain profits. This is also called “retained earnings” which is nothing more than another word for profit retention.
Example: A company has achieved net profits in a certain year or in other words, a positive result. The reserves are now “allocated” from this annual surplus. This can also be called: Retention of profits and allocation to reserves. It means nothing more than the addition to retained earnings, which in principle represents an increase in equity and thus an increase in the equity ratio. If we deduct the “allocation to reserves” from the “annual surplus”, then the retained earnings remain, which are paid out to shareholders as dividends. Dividends are what is distributed from “what is left over”. Before that, the reserves are “endowed” and the result is that the equity capital increases and thus also the equity ratio.
These are the two ways to increase the capital. The easiest way to do this in a corporation is to retain profits. “Retaining profits” or you can also say “simply retain more of the annual net profit and distribute less to the shareholders”. But you can also release capital on the assets side. If you want to free up capital, take a closer look at the fixed assets. For example, there is an unused warehouse and a plot of land. If a building or a piece of land is no longer needed, it can be sold and turned into cash. However, this does not initially increase the equity ratio. It only increases liquidity in the first step. This is a process on the asset side, i.e., nothing more than an asset swap. The company has correspondingly less in fixed assets because the warehouse and the associated land disappear from fixed assets and at the same time the company has more liquid funds in the bank due to the receipt of the sales proceeds. The fixed assets decrease, the current assets increase. The total assets remain the same. Consequently, the total capital on the liabilities side also remains the same.
This process offers the possibility to indirectly increase the equity ratio. If, in a second step, a loan is repaid with this money, then we are on the indirect path of increasing the equity ratio and thus reducing the debt capital. The indirect way is for example a loan repayment, in our example using the proceeds from the sale of the warehouse.
Through the loan repayment:
– debt capital becomes lower,
– equity capital remains the same,
– total capital decreases and thereby the equity ratio increases!
All measures that reduce “the balance sheet total” – increase the equity ratio. Keeping equity the same and reducing the balance sheet total is therefore the indirect way to increase the equity ratio.
So how can you reduce “the balance sheet total”?
For example, by optimizing inventories in current assets. Inventory is reduced by “just in time” measures which reduces holding inventory on site.
Another item to improve the equity ratio can be found in current liabilities. Debt capital is subdivided into current liabilities and long-term liabilities. If fewer short-term liabilities appear on the balance (because invoices are paid more quickly) then the equity ratio is increased accordingly because the debt capital is reduced, which is made up of long-term and short-term liabilities. Repaying long-term loans and reducing short-term liabilities are also ways to increase the equity ratio. If your company cannot utilize the above-mentioned methods, and your options are limited to increase equity or the equity ratio to trigger grants and funding, structured Credit Enhancement processes may offer a solution.
Here is a great example of how Credit Enhancement methods are applied to increase equity in a company without having to search for an investor and share profits. In this scenario, a private bank or a financial institution invests into a company’s stock to become an equity investor through a SPV. The investment into the company equity will be for an agreed period:
- A Private Share Purchase and Sales Agreement
- The client agrees to sell equity shares in return for the bank’s investment
- The client agrees to buy back the shares within the agreed upon period
- Client opens an account with the bank
- Client delivers the shares to the bank
- The Bank funds the account and place cash funds into the client’s account at the bank
- Cash funds are on deposit at the bank for the agreed upon time.
After the agreed term, which can be up to 3 years, the client buys back the shares against the (release of the) funds on deposit with the bank. Clients can benefit from this form of credit enhancement if they want to accomplish further steps like triggering loans, triggering Grants, or funding from Governments, or through other banks or funders. The account statement in that case serves as Credit Enhancement (tool) and is confirmed on a bank-to-bank basis.
The beneficiary could be a Solar-, Wind- or Hydro Power projects seeking access a PPA from a Government, grants, or loans available if they can show (for example) 30% equity. The local bank will provide a loan of 70% without the need for a Bank Guarantee and the Government provides the PPA.
Here are some other Credit Enhancement tools. Basically these are financial instruments which may come in these formats and are usually advised on a bank-to-bank basis, like L/C and DLC – Letter of Credit and Documentary Letter of Credit, SBLC – Standby Letters of Credit, BG – Bank Guarantee, Bid or Tender Bond, RWA – Ready, Willing, Able confirmation, POF Proof of Funds and BCL Bank Comfort Letter, BF– Blocked Funds, CD –Certificate of Deposit, Pre-Advice via bank to bank SWIFT
Chances to materialize a transaction can be very high if the borrower’s company is of substance. If you would like to discuss this further, please use the reply form, or call 00353860325153. This number also works on Whatsapp, Signal, Telegram and WeChat.
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Banks must have a balance between the assets they hold or have in custody and the credit lines to customers. This relationship has become increasingly stringent over the past decade. The collapse of Silicon Valley Bank raises again fears of new financial crisis. Despite authorities' efforts to limit the impact of bank's failure, investors fear a spillover. Banks have many illiquid assets that do not allow them the necessary manoeuvrability to open lines of credit. For this reason, banks are looking for liquid collateral that can counterbalance the relationship between assets/loans, allowing banks the ability to operate within central bank regulations. NOTE: The content of this report is part of an abstract of the 577-page book we make available to our contracted clients providing guideline to successfully structure project finance with the help of third-party collateral and Prime Bank Guarantees. It is widely read by private sector investors and lenders who intend to make project finance deals.
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