What is Equity?

What Is Equity?

As the name suggests, equity is the amount of money shareholders (or owners) of privately held companies would get if all the assets of the company were liquidated and all of the company’s debts were paid off in the event of liquidation. When a company is acquired, it is the sale value less the liabilities owed by the company that were not transferred.

Furthermore, shareholder equity can be used to represent a company’s book value. There are times when equity can be offered as a form of payment-in-kind. Also, it represents a company’s pro-rata share ownership.

The equity of a company can be found on its balance sheet and is a common indicator of a company’s financial health.

Understanding Equity

When you first start a business, you (along with any co-owners) typically put some of your own assets into the company. Those original contributions form the first entries in your equity account, and get your business on its way. Adding resources into the company is one way to beef up your equity account, whether those resources come from you and other involved owners or from silent investors. 

Any asset you personally put into the business increases your equity stake. The most commonly contributed asset is money, but all other personal assets that are used exclusively by the company count as well. Contributed assets can be anything from a laptop computer to a backyard shed to a pickup truck that now bears your company logo. For major assets like that pickup truck, it’s important to retitle the asset in the company name to avoid any problems down the line, such as the IRS questioning ownership (after all, you can’t claim depreciation expense on a personal vehicle).

It’s not uncommon for new companies to end up with negative equity after their first year or two in business. This happens when early losses are greater than the initial capital investment. It indicates the business is struggling, but things can turn around with workable ideas for boosting revenues.

Equity represents how much of your company is really yours, and not owed to someone else. Think of it the way you think about your house: You may own your house, but the bank probably has a claim on part of it, too, in the form of your mortgage. Here, your house is your asset, your mortgage is your liability, and the part of your house that you truly own (the difference between its value and your outstanding mortgage balance) is your equity. It’s exactly the same for business. You have your assets, you owe your liabilities, and you own your equity stake.

Equity Split 

The main split among equity accounts, common to all business types, is in which direction the capital is flowing. There are: 

  • Equity contributions, which means owners put more of their own cash into the company. 
  • Equity withdrawals, which means owners take money out of the company, but not as regular salary. 
  • Current profit or loss that becomes a permanent piece of the equity account. As you might expect, profits increase equity, while losses decrease it. 

The best way to grow the equity of a company is to keep some of the profits that the company earns inside the business. Many small business owners like to take out profits as soon as they’re earned. After all, they’ve had to pay tax on the money, and they want to enjoy the benefits of the money they earned. If you’re planning to expand your company, though, leaving some of those profits inside is a great first step toward growth. It can also make your company more attractive to prospective lenders, as banks are often more likely to make a loan when they see there is substantial equity at stake. 

Which Kind of Equity Is It?  

When it comes to business, equity comes with a bit of a twist. Though equity is about ownership no matter what type of company you have, the accounts you use depend entirely on your business structure. Different business structures include: 

  • Sole proprietorships 
  • Partnerships 
  • Limited liability companies (LLCs) 
  • S corporations 
  • C corporations 

The structure of your company dictates how the equity looks for accounting purposes, and exactly what types of equity accounts that appear in your books. 

Sole proprietorships and partnerships have a separate owner’s equity (or capital) account for each owner, along with a corresponding withdrawal account for each. The owner’s equity account is a permanent account, and contributions are made directly into this account. The withdrawal accounts are temporary and are folded into the owner’s equity account at the end of the accounting period, along with that period’s net profit or loss. 

Corporations don’t have equity accounts directly geared toward individual owners. Instead, they have accounts for each type of stock they issue to represent the contributed capital, plus a special account called “additional paid-in capital” (for contributions greater than the par value of the stock).

Unlike sole proprietorships and partnerships, no other accounts are folded into these. Earnings at the end of the period are held in the retained earnings account. Owner withdrawals are a much more formal affair, and here they exist only in the form of dividends. The dividends account is temporary, and is rolled into retained earnings at the end of the period.

An Overlooked Statement Clears Things Up 

Along with the big three financial statements (the balance sheet, the statement of profit and loss, and the statement of cash flows), there’s a fourth less often used report called the statement of changes in owner’s equity. This report walks readers through how the equity has grown (or decreased) during the fiscal period (the same period used for the statement of profit and loss). 

This simple, short statement starts with the opening value of owner’s equity (whatever form it takes) from the beginning of the period. Next, the document lists the changes to equity, adding the increases and subtracting the decreases. Increases include net profits and capital contributions; decreases include losses and owner withdrawals. 

The bottom line of this statement gives you the current balance of the owner’s equity. That presents a complete picture of the true value of the company; its net worth. The most important way a company can grow its net worth comes from the results of its operations, in the form of (hopefully) profits.

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