When you hear the word “equity” what comes to mind? For many, it conjures images of ownership, value creation, and growth – essential pillars of financial success. However, on a balance sheet, equity tells a deeper story.
Equity is more than just a measure of assets minus liabilities; it reflects the accumulated history of a company, from its initial capital infusion to the profits it has retained – or the losses it has endured. In a world driven by balance sheets, equity provides the crucial link between what a company owns, what it owes, and, ultimately, what it’s worth.
So, what is equity, what does it reveal about a business, and why should investors care?
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What Is Equity?
Equity is the residual interest in an entity’s assets belonging to shareholders after deducting all liabilities. It reflects what shareholders would receive if all the company’s assets were sold and all liabilities settled. In essence, equity is the net worth of a company.
The accounting equation is the formula that defines equity and governs all financial position statements. It is as follows:
Assets – Liabilities = Equity
Since equity is the residual interest in a company’s assets belonging to shareholders, shareholders would benefit from any increase in asset value after deducting liabilities. On the contrary, shareholders would bear the loss of any reduction in asset value after accounting for liabilities.
Take the following scenarios as examples.
Say a company (Example Industries) has £100 million in assets and £60 million in liabilities. Equity would equal £40 million (£100 million – £60 million). If all assets were sold and all liabilities settled, shareholders would be entitled to a share of the £40 million.
If Example Industries increases assets to £130 million with the same £60 million in liabilities, the residual interest belonging to shareholders would increase to £70 million. Existing shareholders would be £30 million better off (£70 million now versus £40 million then).
On the other hand, if Example Industries’ assets fell to £70 million with the same £60 million in liabilities, equity would now be a mere £10 million. Existing shareholders would be £30 million worse off (£10 million now versus £40 million then).
Because of the accounting equation, a change in liabilities also affects equity. If liabilities rise and the value of assets remains the same, equity will be reduced. If liabilities are reduced and the value of assets remains the same, equity will increase.
Main Components of Equity
Equity is an entire section on a company’s statement of financial position, not a single line item. The accounts included in equity vary from company to company, but the three main ones are as follows.
Share Capital (Common Stock)
Share capital, also called common stock, represents the portion of a company’s equity raised by issuing shares. Share capital is the total cash stated at par value (the original value of the shares when they were first sold) that shareholders have contributed to the company. The formula for calculating share capital is as follows.
Share Capital = Par Value of Shares x Number of Issued Shares
For example. If a company issues 100,000 shares worth £0.50 at its initial public offering (when it starts trading on the stock market), its share capital would be £50,000 (100,000 x £0.50). £0.50 is the par value.
Share capital and common stock represent the same thing on a company’s statement of financial position. The term used depends on the company’s country of origin and the financial reporting standards that the country abides by. European companies usually use the term share capital because European countries follow the International Financial Reporting Standards (IFRS). American companies use common stock because America follows Generally Accepted Accounting Principles (GAAP).
Share Premium (Additional Paid In Capital)
Share premium, also called additional paid in capital, represents the surplus cash a company receives for issuing shares above par value. It reflects the excess amount investors pay over the original worth of a company’s shares. The formula for calculating share premium is as follows.
Share Premium = (Issue Value – Par Value) x Number of Issued Shares
For example. If a company issues shares with a par value of £1 for £5, £1 would be recorded as share capital and the additional £4 as the share premium. In financial accounting, this is how such a transaction would be recorded – account for the share capital based on par value and account for the excess above par value as share premium.
Like share capital and common stock, share premium and additional paid in capital represent the same thing on a company’s statement of financial position. The term share premium is used by European companies and additional paid in capital by American companies for the same reasons as above.
Retained Earnings
Retained earnings represent the portion of a company’s accumulated profits that weren’t paid to shareholders as dividends. Instead of being distributed, these earnings are reinvested to fund future business growth and pay down debt.
Because retained earnings represent a company’s accumulated net profit over its life, retained earnings are heavily affected by net profit. Therefore, the formula for calculating retained earnings is as follows.
Retained Earnings = Beginning Retained Earnings + Annual Net Profit – Dividends Paid
Beginning Retained Earnings is the company’s ending retained earnings figure from the previous year.
If Examples Industries has retained earnings of £50 million from the previous year, generated £20 million in annual profit and paid £5 million in dividends, its retained earnings at the end of the current year would be £65 million (£50 million + £20 million – £5 million).
The term retained earnings is used by European and American companies alike.
Negative Equity
Until now, we’ve assumed that equity is always a positive figure. But can equity be negative?
Yes, it can.
Negative equity is a consequence of a company’s liabilities exceeding its assets. The negative balance means that a company owes more than it owns. If a company has £100 million worth of assets and £150 million worth of liabilities, it will have negative equity of £50 million (£100 million – £150 million).
Alongside taking on debt without a corresponding increase in assets, companies can get a negative equity balance by:
- Generating consistent losses – losses reduce retained earnings and, by extension, the entire equity section.
- Write-downs – considerable reductions in asset value due to impairment can result in liabilities exceeding assets.
- Paying dividends even when generating an annual loss – annual losses and paying dividends individually reduce retained earnings and equity. Combining the two only exacerbates the issue.
When a company has negative equity, it can be a signal of:
- Financial instability – if all company assets are sold, they won’t cover all liabilities.
- Difficulty raising capital – companies with negative equity may find it difficult to raise new capital or obtain loans, as lenders and shareholders may view them as high risk.
- Risk of bankruptcy – extended periods with negative equity can lead a company into insolvency or bankruptcy, especially if it cannot generate enough cash to pay its debts and other obligations.
Companies can recover a negative equity balance by generating and retaining more profits, increasing assets and paying down liabilities.
Summary
Equity on a balance sheet is more than just a snapshot of a company’s financial standing. It represents a company’s journey, highlighting the impact of past decisions, investments, and performance. From the fundamental equation of assets minus liabilities, equity reveals the value belonging to shareholders and provides insights into the company’s financial health.
Positive equity signifies a robust foundation and potential for growth, while negative equity serves as a critical red flag, signalling potential risks and financial instability.
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