Proprietary Ratio

The proprietary ratio is a financial ratio that measures the proportion of a company's total assets that are financed by its shareholders' equity. Its purpose is to assess the extent to which a company relies on equity financing to support its operations and growth.

It is a useful financial measure for evaluating a company's financial stability and risk profile. The ratio is relevant for investors and creditors interested in understanding how much a company relies on equity rather than debt financing. It is also be used to compare a company's financial structure over time or with other companies in the same industry.

• The proprietary ratio evaluates a company's financial stability by assessing the percentage of its total assets financed by proprietors' or shareholders' funds.
• The calculation formula is Proprietary Ratio = Proprietors' Funds or Shareholders' Equity / Total Assets.
• A favorable proprietary ratio is typically 0.5 or higher, indicating that its capital funds at least 50% of a company's assets.
• This ratio is useful for investors, creditors, and financiers to assess a company's long-term credibility and risk profile.

The proprietary ratio is a measure of a company's financial leverage, which indicates the extent to which it is shareholders' equity to finance its operations. As a business is typically funded by two sources of capital - internal and external, with external funding coming from sources such as loans and other borrowings from creditors like banks, the proprietary ratio can help determine the extent to which a company is relying on equity financing which is an example of internal funding to support its operations and growth.

By dividing shareholders' equity by total assets, the proprietary ratio reveals the percentage of a company's overall assets that are availed by employing internal capital. This metric is useful for investors, creditors, and analysts interested in evaluating a company's financial health and risk profile.

While the proprietary ratio can be a useful financial measure, it may not always accurately reflect a company's capitalization. For example, off-balance sheet debts may be overlooked during evaluation, leading to an inflated value of this ratio and a false interpretation of the company's financial position. Additionally, a company's equity and debt proportions can vary significantly depending on its stage in the business life cycle. While a high proprietary ratio may be attractive for an early-stage startup, the company may have limited earning potential and require substantial investment to grow.

It's also important to note that some businesses, such as capital-intensive industries, may require substantial debt financing while maintaining high profitability. Therefore, relying solely on this ratio to evaluate such companies may not be appropriate. Ultimately, it is up to investors and proprietors to determine the appropriate balance of equity and debt financing based on their risk tolerance and investment goals.

The proprietary ratio is a tool to understand the firm's financial efficiency in the long run. It thus determines the proportion of the stockholders' equity to the business's total assets. It is mathematically represented as:

 Proprietary Ratio Formula = Proprietors' Fund / Total Assets

Proprietors' funds include equity share capital, preference share capital, reserves, and surplus. Total assets refer to all company-owned assets, including fixed assets, current assets, investments, and other assets.

Suppose a company has total assets worth $100,000, and its proprietors' funds include equity share capital of $50,000 and reserves of $30,000. Then, the proprietary ratio for this company can be calculated as follows:

Proprietary Ratio = Proprietors' Funds / Total Assets 

= ($50,000 + $30,000) / $100,000 

= $80,000 / $100,000 

= 0.8 or 80%

This means that the company has financed 80% of its assets using its funds, which indicates that it is less reliant on external financing and has a strong financial position.

The proprietary ratio as a solvency ratio provides a sense of the percentage of assets shareholders would receive if the firm were to liquidate. A high proprietary ratio signifies the company's strong financial position, as a larger portion of its assets is financed by equity. This suggests that the company is relying less on the debt financing method and has a healthier balance sheet, which can help ensure financial stability in the long run. On the other hand, a low proprietary ratio may indicate that the company is relying heavily on debt financing, which can be a cause for concern as it may lead to financial instability in the long term.

A high ratio indicates that the company's capital structure is strengthening, and the business is increasing its shareholders' capital while decreasing its debt obligations. This also helps the firm to secure the credibility of the creditors, financiers, and investors. Additionally, the risk of insolvency or bankruptcy reduces considerably, which means the availability of loans at a lower interest rate. However, if the proprietary ratio is too high, the management cannot utilize the debt financing options wisely to generate profit.

A ratio value below 0.5 or 50% indicates that the business relies more on leveraged funds. This could indicate that the company is in significant debt, and its profitability may be affected. Investors and creditors may also perceive such investments as higher risk, leading to difficulties securing funding or investors. Therefore, a low proprietary ratio may not always be a good sign for the company's financial health.

This has been a guide to what is Proprietary Ratio. We explain it in detail with its formula, interpretation, and calculation example. You can learn more about from the following articles –

• Accounting Ratios
• Solvency Ratios
• Financial Ratios