Proprietary Ratio – Meaning, Formula, Example, and Calculation

In the world of financial analysis, understanding key metrics is crucial for evaluating a company’s stability, profitability, and long-term viability. Among these essential metrics, the proprietary ratio stands out for its importance in assessing financial health. This ratio reveals the proportion of a company’s total assets that are financed by shareholders’ equity, offering a clear view of its capital structure and risk profile. 

A higher proprietary ratio indicates strong equity reliance, signifying reduced financial risk, while a lower ratio points to a higher dependency on debt. For investors, creditors, and analysts, mastering this metric provides valuable insights into a business’s stability and sustainability.

What is the Proprietary Ratio?

This ratio is a solvency formula that measures the degree of the total assets funded by shareholder equity. It is useful to assess financial stability as it shows the extent of its usage of equity and debt for funding activities. This metric is useful when evaluating company risk and stability of the capital structure, and therefore, it will be helpful to investors, creditors, and financial analysts.

Significance of the Proprietary Ratio

This ratio indicates a business's financial stability. A high proprietary ratio means a greater percentage of assets are financed by equity and less by debt, indicating lower financial risk. On the other hand, a low proprietary ratio suggests heavy reliance on external funds, leading to a higher level of financial risk.

Proprietary Ratio Formula 

The formula of the proprietary ratio is straightforward, as shown below:

Proprietary Ratio = Proprietors' Funds / Total Assets

• Proprietors' Funds: Includes equity share capital, preference share capital, reserves, and surplus.

• Total Assets: Represents all assets, including fixed assets, current assets, investments, and deferred revenue expenses.

Ideal Proprietary Ratio

An ideal value for a proprietary ratio often exceeds 0.5 or 50%, implying that half of companies’ assets should be financed by equity. The proprietary or equity ratio calculates the amount of a corporation’s total assets funded through shareholders’ equity. 

It is one of the key liquidity ratios indicating how a firm will finance its operations through internal or external financing. For stakeholders, this ratio is very useful, as it gives an overall idea about a business entity's financial soundness, solvency, and risk-taking ability.

Additionally, depending on the stage of the business cycle of a company, there can be significant variations in its equity and debt proportions. While a high proprietary ratio can be found attractive for a company in its early stages, it may have limited earning potential and may require substantial investment to grow.

The ideal proprietary ratio may vary based on the industry, especially for companies that operate in sectors requiring significant capital expenditures, often financed through debt, while also maintaining high profitability. Therefore, solely relying on this ratio to assess such companies may not be the best approach.

How to Calculate Proprietary Ratio 

Let’s explore the calculation of the proprietary ratio with two examples for a better understanding:

Example 1: Company A

• Proprietors' Funds: Rs 50,00,000

• Total Assets: Rs 1,00,00,000

Proprietary Ratio = Rs 50,00,000 / Rs 1,00,00,000 = 0.5 (50%)

Interpretation:
Company A has 50% of its assets financed by equity, indicating a balanced financial structure with moderate reliance on equity and debt.

Example 2: Company B

• Proprietors' Funds: Rs 30,00,000

• Total Assets: Rs 1,20,00,000

Proprietary Ratio = Rs 30,00,000 / Rs 1,20,00,000 = 0.25 (25%)

Interpretation:
Company B has only 25% of its assets financed by equity, suggesting a higher reliance on debt, which may pose financial risks.

Proprietary Ratio Interpretation

• High Ratio: Suggests a strong financial position, reduced insolvency risk, and enhanced credibility with creditors. However, excessive reliance on equity might indicate the underutilisation of debt financing for growth. A value of 0.5 (50%) or more is considered favourable, indicating that at least half of the company’s assets are financed by equity. This suggests strong financial health, reduced reliance on debt, and a lower risk profile.

• Low Ratio: Implies significant debt reliance, higher financial risk, and potential challenges in obtaining further credit or investment. A ratio below 0.5 indicates a higher reliance on debt financing, which could signal financial instability or increased risk of insolvency.

A high proprietary ratio reassures creditors and investors about the company’s ability to manage its obligations without excessive reliance on borrowed funds. Conversely, a low ratio may deter creditors and investors due to perceived financial risks.

Importance of Proprietary Ratio

• Indicates financial independence and solvency.

• Helps creditors and investors assess risk and stability.

• Provides insights into the company’s ability to withstand financial challenges.

Limitations of Proprietary Ratio

• Off-Balance Sheet Items: Exclusion of certain assets or liabilities can skew the ratio.

• Industry Differences: Capital-intensive sectors typically exhibit lower ratios due to greater debt reliance.

• Business Lifecycle Impact: Startups often depend heavily on equity, whereas established companies tend to adopt a more balanced approach to equity and debt.

Conclusion

The proprietary ratio is a key indicator for evaluating a company's financial structure, shedding light on its reliance on equity versus debt. Although it serves as a valuable benchmark for assessing financial health, it should be analysed in conjunction with other financial metrics for a comprehensive understanding of the company's solvency and risk profile.

FAQs

Q1. What does the proprietary ratio indicate?
The proprietary ratio highlights the proportion of a company's total assets funded by shareholders' equity. It helps assess financial stability, solvency, and reliance on equity versus debt for financing.

Q2. What is considered an ideal proprietary ratio?
An ideal proprietary ratio is generally above 0.5 (50%), indicating that at least half of the company's assets are financed through equity. However, the ideal value can vary by industry and business model.

Q3. How does a high proprietary ratio benefit a company?
A high proprietary ratio reflects a strong financial position with reduced insolvency risk and lower dependency on debt, which boosts credibility with investors and creditors.

Q4. Can a low proprietary ratio be a concern?
Yes, a low proprietary ratio indicates a higher reliance on debt, which increases financial risk and may signal potential difficulties in managing obligations or obtaining further credit.

Q5. Why is the proprietary ratio important for financial analysis?
The proprietary ratio provides insights into a company’s financial independence, stability, and risk profile. It helps stakeholders evaluate the company's ability to withstand challenges and maintain solvency.