Proprietary Ratio - Meaning, Assumptions and its Interpretation

The proprietary ratio is not amongst the commonly used ratios. Very few analysts prescribe its usage. This is because in reality it is the inverse of debt ratio. A higher debt ratio would imply a lower proprietary ratio and vice versa. Hence this ratio does not reveal any new information.

Formula

Proprietary Ratio = Total Equity / Debt + Equity

Meaning

The proprietary ratio is the inverse of debt ratio. It is a part to whole comparison. The proprietary ratio measures the amount of funds that investors have contributed towards the capital of a firm in relation to the total capital that is required by the firm to conduct operations.

Assumptions

  • No off Balance Sheet Debt: The presence of off balance sheet debt may understate the total debt that the firm has. This in turn will overstate the proprietary ratio. Such accounting can be thought of as deceptive because it masks the true risk profile of the business. However, since accountants would be on the right side of the rules, it is not incorrect for them to do so.

Interpretation

  • Depends on Risk Appetite: The ideal value of the proprietary ratio of the company depends on the risk appetite of the investors. If the investors agree to take a large amount of risk, then a lower proprietary ratio is preferred. This is because, more debt means more leverage means profits and losses both will be magnified. The result will be highly uncertain payoffs for the investors.

    On the other hand, if investors are from the old school of thought, they would prefer to keep the proprietary ratio high. This ensures less leverage and more stable returns to the shareholders.

  • Depends on Stage of Growth: The ideal value of the proprietary ratio also depends upon the stage of growth the company is in. Most companies require a lot of capital when they are at the early stages. Issuing too much equity could dilute the earnings potential at this stage. Therefore a lower proprietary ratio would be desirable at such a stage allowing the firm to access the capital it wants at a lower cost.

  • Depends on Nature of Business: The firm has to undertake many risks and balance them out. There are market risks which are external to the firm and there are capital structure risks that are internal to the firm. If the external risks are high, the firm must not undertake aggressive financing because this could lead to a complete washout of the firm. On the other hand, if the external environment is stable, the firm can afford to take more risks.


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