If you want to understand business finance, then it’s important to understand the concept of equity. Equity is one of the most common ways to evaluate a company’s financial stability. Let’s look at how equity works, how it’s calculated, and the different types of business equity.
What is equity?
Equity is the value of your business after deducting your liabilities from your assets. It’s the total amount of money that would be returned to your shareholders if your debt was paid off and your assets were liquidated.
If you run a corporation, it’s often referred to as “shareholder’s equity” since it refers to the shares of stock owned by your company’s investors. If you’re a sole proprietor or single-owner LLC, equity may be referred to as “owner’s equity.” Owner’s equity is used to determine a company’s valuation.
How do you calculate equity?
Equity is often included on a company’s balance sheet, and analysts often use it to evaluate a business’s financial health. Investors can look at equity to help them determine whether a company is worth investing in and whether it’s able to expand into new markets.
You’ll use the following formula to calculate equity:
Equity = Assets - Liabilities
You’ll locate the company’s assets on the most recent balance sheet to calculate equity. Then you’ll make a note of that company’s liabilities. Once you subtract the liabilities from the assets, you’ll have the shareholder equity. In accounting, a company’s assets will always equal its total liabilities and total equity.
[Read more: Private Equity vs. Venture Capital: What’s the Difference?]
What are assets and liabilities?
Assets are any company's resources, including tangible and intangible assets. They can also be fixed or current — current assets can be converted to cash within a year, while fixed assets are for long-term use and aren’t easily converted to cash.
Here are some examples of assets:
- Cash.
- Accounts receivable.
- Inventory.
- Trademarks.
- Raw materials.
Liabilities include any debt the company owes, which will usually appear next to the assets section on the balance sheet. Here are some examples of common business liabilities:
- Short-term or long-term loans.
- Accounts payable.
- Payroll.
- Federal and state taxes owed.
- Deferred revenue.
Equity is often included on a company’s balance sheet, and analysts often use it to evaluate a business’s financial health.
Types of business equity
Let’s look at the most common types of business equity you’ll encounter.
Common stock
Common stock represents ownership in a company, and it gives shareholders the right to certain assets. Investors with common stock tend to have more control over the direction of the business. They may help determine company policies and have a say in who joins the board of directors.
Preferred stock
Preferred stock is similar to common stock, but these shareholders have fewer responsibilities and less say in how the business is run. But preferred stockholders can receive dividends and have the right to claim a company’s assets.
Treasury stock
Treasury stock refers to shares the business buys back from its investors. It’s usually reflected as a deduction from the company’s total equity and usually has a negative balance.
Retained earnings
Your retained earnings account shows the business’s total earnings minus any dividends paid to shareholders. Retained earnings are the net income you didn’t pay out as dividends and can be used for investments.
What is equity financing?
Some startups will choose equity financing as a way to raise money without taking on business debt. With equity financing, business owners receive funding from an investor in exchange for a percentage of ownership in the company.
For example, let’s say you run an e-commerce business and need funds for additional inventory. You could give an investor 15% ownership of your business in exchange for the capital you need to expand your business operations. However, that investor now has a 15% stake in your company and has the right to contribute to all business decisions.
[Read more: How to Attract Private Equity Investors]
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