What is Equity: Calculation, Types, and Importance

# What is Equity: Calculation, Types, and Importance

Jaya Sharma
Assistant Manager - Content
Updated on Feb 6, 2024 16:35 IST

Equity is the difference between the total assets and liabilities indicated through the company balance sheet. Over the course of accounting periods, it changes for individuals as well as businesses.

In this article on what is Equity, we will also discuss how is equity calculated, changes and its different types.

## What is Equity?

The term equity refers to the amount of money that the company owns from its shareholders. The company is liable to return its shareholders under certain conditions. The equity represents the book value of the company and pro-rata ownership of a company’s shares. This means the one with equity has a share of a company. It can be found on the balance sheet to help assess the financial health and net worth of a company.

### Calculation of Equity in a Company

For calculation, one can consider one of the following equations:

Shareholders’ Equity = Total Assets − Total Liabilities

Or

Shareholders’ Equity = (Company’s share capital + retained earnings) – Value of treasury shares

Here:

1. Retained Earnings: These represent the percentage of net earnings not paid to shareholders as dividends. These are the cumulative profits that the company retains for future use. As these retained earnings grow large in the future, the amount exceeds the equity capital amount which has been contributed by stockholders. These make up the biggest chunk of stockholder’s equity for companies that stay operational for many years.
2. Treasury shares: These are the stocks that have been repurchased from their existing shareholders. This helps in optimizing available equity capital for maximum results. The dollar value of these treasury shares is noted in the treasury stock. Whenever the company needs to raise capital, it can reissue the treasury shares to the stockholders.

## Types of Equity Shares

The following are the types of equity shares:

• Bonus shares: These are add-on shares that form the part of a company’s accumulated earnings. Company offers these shares free of cost to its shareholders.
• Rights shares: These are the issues of shares that the company offers at a discounted price to the existing shareholders. Company’s shareholders must fulfill the minimum criteria for subscription of right shares.
• Sweat equity: This type of equity is issued by company to employees and directors at discount for the non-cash consideration.
• Employee stock options: This is an equity compensation that the company grants to employees and executives. Company offers derivative options on the stocks instead of directly offering shares on stocks.

## Importance of Equity in Finance

Equity in finance is like owning a piece of a company. Imagine you buy a slice of your favorite pizza; that slice is yours, right? Similarly, when you buy equity, or shares, in a company, you own a small part of that company. Here's why it's important:

1. Ownership: Buying equity means you're one of the owners of the company, even if it's a tiny part. It's like having a claim on a piece of the business and its future profits.
2. Profit Sharing: If the company makes money and decides to share profits, you get a piece of that. Think of it as getting a share of the pizza toppings because you own a slice.
3. Value Growth: If the company does well, the value of your slice (share) can go up. So, you could sell your slice later for more than you paid for it, making a profit.
4. Voting Rights: Often, owning equity gives you the right to vote on important company decisions, like choosing the board of directors. It's like having a say in what toppings go on the pizza next time.
5. Risk and Reward: Equity can be risky—like if the company doesn't do well, the value of your slice might go down. But with the higher risk there is a potential for higher rewards, meaning if the company grows, so does the value of your share.

## Understanding Equity With Example

To practically understand what is equity, let us consider an example.

Suppose, you own a vehicle worth \$50,000. Out of the total cost, you owe \$30,000 to the bank as a loan for buying the vehicle. Through the above equation of subtracting liabilities from assets, we will know the amount of equity you have. Here, it is equal to \$20,000 in this case.

### Changes in Equity

The statement of changes in equity is a financial statement that explains changes in the share. These changes are reported from one accounting period to another.

1. Investments: Cash inflow from outside sources increase its base capital and the capital surplus by the amount contributed.
2. Accumulated results: Depending on net balance, profit and losses accumulate into account called “retained earnings”/ “accumulated deficit”.
3. Unrealized investment results: Changes in the value of firm-owned securities, and foreign currency holdings, are also accumulated.
4. Dividends: It changes since retained earnings reduce when companies pay out dividends to their shareholders.
5. Stock repurchases: On the repurchase of shares into its treasury, the inquiry changes. The amount paid for these stocks is reflected in treasury stock account.

If assets are subtracted from liabilities, it can help in providing actual data related to a company’s finances. It is. Through issuing equity, companies can raise capital. This helps in the growth of the firm. There are many other benefits, including the following:

1. It indicates the value of an investor’s stake in the company.
2. Shareholders get the right to vote on corporate actions and elections for Board of Directors.
3. It is used by companies as the capital raised for investment in assets, operations, and projects.

The word equity can have both positive and negative contexts. When there is positive equity, it represents that the company has enough assets to cover its liabilities. If it is negative, it represents that the company has more liabilities than its assets.

This directly leads to balance sheet insolvency. If the shareholder equity goes negative, it is a red flag in investing. They will view the company as a risk-prone investor. Ultimately, negative shareholder equity causes a loss of investment opportunities for the company.

As per the theory of intrinsic value, if a company’s stock is priced below the present value of its equity, it is profitable to pick stocks. The shareholder equity balance does not impact the investor’s decision to sell a stock at a certain price.

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## Types

There can be different ways of classifying its types. It can either be classified as per the entity or as per its calculation. Let us consider both.

### 1. Single Assets

When an asset is purchased via a secured loan, it is said to have equity. Until the time the loan is not fully repaid, the buyer does not completely own the asset. The lender can reclaim the asset in case the buyer defaults to recover the unpaid loan amount.

In such a case, the equity balance is the market value of the asset reduced by the remaining loan amount. This measures the partial ownership of the buyer. In case the asset has a deficit, the lender will have to rely on the terms of loan to recover the loan amount.

In case of businesses, the equity indicates the number of assets that belong to the business owner. When it comes to recovering loans in such cases, selling out company assets may help recover money. In some cases, it may be done through specific assets in the business. In other cases, every asset might have to be included.

### 3. Book Value

In accounting, equity is listed into its book value. It is calculated through financial statement records and balance sheet equation. Book value represents the net value of assets of a firm. It is almost equal to the amount shareholders will get if the company gets liquidated. Mathematically, it reflects the difference between a company’s total assets and liabilities.

### 4. Market Value

It represents the company’s worth based on its market capitalization. For public traded companies, market value is calculated by multiplying the share price and shares outstanding. For private companies, accounting firms, boutique valuation firms and investment bankers calculate the market value.

Market value is often greater than book value since it includes the future growth prospect, profitability, and intangibles.

### Conclusion

This concept has several applications including the evaluation of a company. It also has many different types that represent the percentage of ownership in assets while excluding any debts associated with it. We hope that you have been able to understand the concept of equity.

## FAQs

What is equity in layman terms?

Equity is the shareholder or owner's equity for privately held corporations. It is the amount of money that the shareholder of a company gains when all the assets are sold, and debts are paid off.

Is equity a good investment?

Yes, investing in equity is beneficial since it increases the value of the principal amount that has been invested. Along with this, the investor earns through dividends and capital gains.

Explain Return on Equity (ROE).

ROE indicates the management's ability to generate income from the available equity. It comes in handy while comparing the financial performance of companies within one industry.

Define a good return on equity (ROE)

15-20% return is considered a good ROE.

How do investors use equity?

For investors, if a company has positive equity, that means it is worth investing in. In case, the equity is negative, investors would avoid investing their money in the company.