Equity is an important financial term with varying meanings. Often when someone says equity, they mean either owner’s equity/ shareholder’s equity. It represents the net worth or book value of a company or a business.
This blog post is divided into the following sections:
Table of Content
What is equity?
The equity of a company, also known as the shareholders’ equity, represents a company’s net worth. It is the amount returned to the shareholders in case of liquidation of a company.
It can be easily found as a line item in the company’s balance sheet. Equity is a crucial financial metric to evaluate the financial health of a company.
Why is equity important?
Equity represents the value of the company after all the debts have been repaid. The more equity a firm has, the more valued it will be.
Equity is essential for a company because:
1. Indicates financial health
Equity represents the net value of a company and helps in determining its financial health.
2. Assists in business expansion
Through equity financing, business owners can sell their stock shares to investors. This helps the company in the funding of business expansion without bearing any financial burden.
3. Securing an equity investor
Investors are selective about which project to invest in. They are likely to invest in a company having high equity and lower debt.
4. Equity can be used by
• Investors to determine whether a significant quantity of equity has accumulated to demand dividends.
• Lenders do check whether the business has enough funds to pay its debt.
• Supplier to determine whether they can extend credit depending upon the business equity.
How to calculate total equity?
The formula to calculate total equity and how do you find equity is:
Total equity = Total assets – Total liabilities
The alternative method of calculating total equity is:
Total equity = Common stock + Preferred stock + Additional paid-in capital + Retained earnings – Treasury stock
What are the steps of calculating equity?
1. Calculating total assets
Total assets = Current assets + Non-current assets
Current assets are the assets that are realised within an accounting period.
These include:
- Cash and cash equivalents
- Prepaid expenses
- Accounts receivable
- Short term investments
- Inventory
Non-current assets are the assets that are not expected to convert into cash within an accounting year.
These include:
- Tangible fixed assets like land, building, machinery, equipment, furniture, and more.
- Intangible assets like patents, trademarks, goodwill, and more.
- Investments in other subsidiaries and associates
- Investment properties
2. Calculating total liabilities
Total liabilities = Current liabilities + Non-current liabilities
Current liabilities are the short-term financial obligations that the business must pay within one year.
These include:
- Accounts payable
- Accrued or outstanding expenses
- Employee wages and payroll liabilities
- Taxes
- Bank overdraft
- Short term loans
Non-current liabilities are the long term financial obligations due beyond one accounting period.
These include:
- Long term loans
- Deferred compensation
- Capital leases
- Pension obligations
3. Calculating equity
Total liabilities are subtracted from the total assets to determine the company’s equity.
There is an alternative approach to calculating a company’s equity.
Total equity = Common stock + Preferred stock + Additional paid-in capital + Retained earnings – Treasury stock
All the line items under shareholders’ equity from the balance sheet are calculated. Then, these items, including common stock, preferred stock, additional paid-in capital and retained earnings, are added. Treasury stock has to be subtracted from the sum obtained to get total equity.
What is positive and negative equity?
Equity can be either positive or negative.
Positive equity means assets that exceed liabilities. It implies that the company has a surplus after paying all its debts.
On the other hand, negative equity is a red flag. Startups often have negative equity in the first few years.
A company will have negative equity when its total liabilities exceed its total assets. This implies a situation of potential financial distress for the company.
Some of the reasons for negative shareholders equity are:
1. Pre-revenue
Often startups are pre-revenue, meaning negative equity.
2. Over leverage
Borrowing a considerable amount of money to cover the losses can make the company over-leveraged. This big pile-up of debt will appear as a liability in the company’s balance sheet and result in negative shareholders’ equity.
3. Accumulation of losses
Accumulation of losses over the years results in a negative balance of the shareholders’ equity. This is because the net accumulated losses are deducted from the retained earnings.
4. Payments of dividend
Paying dividend that exceeds the company’s profits or retained earnings can negatively affect shareholders’ equity. Large dividend payments combined with financial losses in the successive periods will also show a negative balance of the shareholders’ equity.
5. Repurchase of treasury stock
If a company decides to repurchase its common stock, it leads to equity depletion. Repurchasing a substantial number of shares of common stock can lead to negative shareholders equity.
