Sales to equity is an efficiency ratio that measures the company’s ability to use shareholders’ capital to generate sales. It is an asset utilization metric used by companies to understand the amount of equity that is needed to support a given level of revenue.
In other words, sales to equity ratio reveals the number of net sales generated by investing one dollar of total shareholders’ equity. As a result, this gives a realistic picture of the relationship between a company’s revenue and its total shareholders’ equity.
Profits earned are usually divided amongst shareholders in the form of cash dividends or held by the company in the form of retained earnings. With the guide of this ratio, companies can determine the amount of capital that should be maintained to make payments to short-term assets and bills. For instance, an economy with a fluctuating sales volume, like a rapid increase in sales, might call for the allocation of a higher amount of working capital to maintain higher sales growth.
This ratio is useful if traced over a given time to find any trends you can use for future projections. Trends can be helpful for firms to budget for the amount of equity needed to expand sales revenue in the future. Ideally, this ratio should remain constant as sales revenue grows.
Sales to Equity Ratio Formula
$$Sales\: to\: Equity = \dfrac{Net\: Sales}{\text{Shareholders' Equity}}$$
Net sales can be calculated by subtracting sales returns from gross sales. The average shareholders’ equity is found by summing up the beginning and ending equity and then dividing by 2.
A high ratio implies that the company is efficiently utilizing its shareholders’ equity to enhance sales growth. It is advantageous for the company when the ratio is high as it implies that the company will be able to keep operating and, at the same time, be able to pay dividends to its shareholders.
On the other hand, low sales to equity ratio indicates that the company is not sufficiently utilizing its assets to generate sales revenue.
An increase in this ratio may need further investigation because there are opportunities for management to skew the ratio by decreasing total equity in favor of investors. They can buy back company stock or distribute dividends which interferes with the capital structure of the company. This can create higher interest expenses and serious trouble in future.
Sales to Equity Ratio Example
ABC company is a four-year-old company in the food and beverage industry. To decide if an increase in annual dividends was possible, the CEO decided to hire an independent team to advise the company. Here is the data they gleaned for each year.
| (in thousands) | 2015 | 2016 | 2017 | 2018 |
|---|---|---|---|---|
| Gross sales | 230,000 | 240,000 | 260,000 | 300,000 |
| Sales returns | 30,000 | 20,000 | 18,000 | 33,800 |
| Paid-in capital | 50,000 | 50,000 | 50,000 | 50,000 |
| Average equity | 80,500 | 83,500 | 86,800 | 90,430 |
We can now use the formula to find the sales to equity ratio for each year:
$$2015 = \dfrac{200{,}000}{80{,}500} = 2.48$$
$$2016 = \dfrac{220{,}000}{83{,}500} = 2.63$$
$$2017 = \dfrac{242{,}000}{86{,}800} = 2.78$$
$$2018 = \dfrac{266{,}200}{90{,}430} = 2.94$$
After looking at the trend across all four years, the analyst team concluded that the annual dividends should be maintained at their current rate of $50,000,000 to ensure retained earnings is not affected.
Sales to Equity Ratio Analysis
This ratio is used to determine how efficiently companies are utilizing stakeholder equity to generate sales revenue. It is an asset utilization metric that allows analysts to understand the amount of equity a company requires to support a given level of revenues. It reveals the number of net sales generated by investing one dollar of total shareholders’ equity; for example, a ratio of 5 means that for every dollar allocated in total shareholders’ equity, $5 is generated in revenue.
This ratio is useful in establishing trends for planning purposes. Investors benefit from this trend line as it projects the future, and the budget for the amount of equity needed to expand sales revenue. Ideally, this ratio should remain constant as sales revenue grows.
Another serious consideration is that investors need to go the extra mile to establish the company’s net profit from the sales to support the trend line observed. As a result of these considerations, the sales to equity ratio may not be sufficient enough to arrive at an intelligent conclusion and, therefore, should be used in conjunction with other ratios.
As the ratio varies across different companies and industries depending on the capital structure, a valid comparison can only be drawn when comparing companies within the same industry and with almost a similar capital structure.
Sales to Equity Ratio Conclusion
- It is a metric used by investor-analysts to understand the amount of equity a company requires to support a given level of revenues
- It reveals the number of net sales generated by investing one dollar of total shareholders’ equity.
- A high ratio is an indicator of efficient utilization of shareholders’ equity to support sales and profit
- A low ratio implies that the company is not sufficiently utilizing its assets (total stakeholders equity) to generate sales revenue.
- It is interpreted in terms of dollars generated in revenue as a result of utilizing company assets (total shareholders’ equity) worth one dollar.
- Because it varies across industries, benchmark the ratio against companies in the same industry and with similar capital structure.
Sales to Equity Ratio Calculator
You can use the sales to equity ratio calculator below to quickly calculate the number of net sales generated by investing one dollar of total shareholders’ equity by entering the required numbers.