Sales to Equity Ratio

Definition

The sales to equity ratio is an asset utilization metric that allows analysts to understand the amount of equity a company requires to support a given level of revenues.  Investor-analysts oftentimes track this ratio over time, since it should remain relatively constant as sales revenues grow.

Calculation

Sales to Equity Ratio = Net Sales / Total Equity

Where:

  • Net Sales = Gross Sales - Returns
  • Total Equity:  includes capital stock, paid-in capital in excess of par, as well as retained earnings, which are the portion of net income not distributed to shareholders in the form of dividends.

Explanation

Asset utilization measures allow investor-analysts to understand how well a company uses its assets in operations.  The term "assets" refers to the shareholders' 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.

Related Terms

current assets, current liabilities, working capital, sales to administrative expense ratio, sales backlog ratio, sales per employee, sales to fixed assets, sales to working capital, maintenance to fixed assets ratio