In business and accounting, equity is a very significant term. It is not only used by businesses but investors also use it to make decisions. The term “equity” has various meanings and can be used on different occasions, such as home value, investment, etc. Equity appears on the balance sheet report of the business, and it serves as the final piece of the puzzle that balances the fundamental accounting equation.
In this article we are going to discuss What is Equity in Accounting, what the various types of equity, what are the various components of equity on the balance sheet, and why it is important for businesses. We will try to make it as simple as possible so that people from non accounting and non business background could understand it.
What is Equity in Accounting?
In accounting Equity shows the real value of an asset or investment after repayment of any debt owed. This term is also being used to refer to capital used for funding or to denote a brand’s value. To calculate equity a simple formula is used: Equity = Assets – Liabilities
Equity indicates the residual interest in a company’s assets after deducting all liabilities. It also represents the net worth or ownership value attributable to shareholders. For example, a man owns a house worth $400,000. It has a mortgage loan of $75,000. In this case, the man is said to have $325,000 of equity in the house.
Equity Share formula
As we have discussed, the shareholders’ equity formula is used to calculate a firm’s equity. Let’s now take a better look at the formula and discuss it in detail.
Equity = Total Assets – Total Liabilities
- Total Assets: It is the total value of all the resources owned by the company. Total assets are present in the company’s balance sheet. It is calculated by: Total Assets = Total Liabilities + Total Equity
- Total Liability: It is the sum of all short term and long term obligations that a business owes to external parties. It is mentioned in the company’s balance sheet. Formula to calculate total liabilities: Total Liabilities = Current Liabilities + Long-Term Liabilities.
- Total Equity: Total equity showing the owner and share holder interest in the business after the losses the liabilities from total assets. The basic formula of how to calculate total equity is Total Equity = Total Assets – Total Liabilities.
Types of Equity in Accounting
There are generally four types of equity.
- Owner’s Equity
- Shareholders’ Equity
- Retained Earnings
- Paid-in Capital
Let’s discuss each of these equity types in detail with an example.
Owner’s Equity
It is often referred to as net worth or net assets. It reflects the amount of money the owner has invested in the business, plus accumulated net income. It is a common type of equity in a sole proprietorship. The owner’s equity can be found by
Equity = Assets – Liabilities
Shareholders’ Equity
It represents the residual value of assets remaining for the stakeholders after the deduction of all liabilities. It is often used in large corporations. Shareholders equity can be measured with the help of a formula:
Shareholders’ Equity = Share Capital+ Retained Earnings – Treasury Stocks.
Generally, shareholders’ equity includes the following.
- Common Stock- It represents basic ownership and voting rights.
- Preferred Stock- It is Shares with priority over dividends but usually no voting rights.
- Additional Paid-In Capital (APIC)- It is the extra money paid by investors above the stock’s par value.
Retained Earnings
The total net earnings that a company retained rather than distributed as dividends to shareholders are known as retained earnings. These funds later reinvested in the business for expansion, repayment of debt, or acquisition. These are shown in the shareholders’ equity portion of the balance sheet.
Formula used: Ending Retained Earnings = Beginning Retained Earnings + Net Income (or Loss) – Dividends Paid.
Paid-in Capital
Another name for paid-in capital is contributed capital. It represents the money raised by a business by issuing shares. It represents money directly invested, not generated from operations.
Components of Equity on the Balance Sheet
In a well structured and standard corporate balance sheet, equity contains several unique line items.
- Common Stock: It represents ownership of equity in a corporation.
- Retained Earnings: It is the total income of the company since its start. It is not yet distributed as dividends.
- Treasury Stock: It is Shares that the company has bought back from the open market. This is a negative value, or “contra-equity”.
- Accumulated Other Comprehensive Income (AOCI): It contains the items that led to unrealized gains or losses in equity, such as foreign currency translations. It is not recorded in the income statement.
- Non-Controlling Interest: It is also referred to as minority interest. It is a situation where one company holds a majority stake, usually above 50% of another company, but not 100%. Since the first company or parent company controls the second company or subsidiary company than parent company can consolidate the financials of the subsidiary company.
Importance of Equity in Accounting
Equity is one of the key indicators for a company‘s long term stability and financial strength as it shows the owner’s residual interest in the business. Overall, equity is important as it provides insight into profitability, risk, and financial sustainability.
- Valuation: Equity helps to determine the real value of a business. It shows how much the business is worth if all the assets of the company are sold and the debts are repaid. It is used by investors to determine whether a company is overvalued or undervalued.
- Solvency: If a company has a higher value of equity compared to the debts it owes, that means the company has a lower reliance on borrowed funds. Lower reliance on borrowed funds reduces the risk of bankruptcy or financial distress. It indicates the ability of the company to bear the losses.
- Key Ratios: Equity plays a central role in various important financial ratios. Return on Equity is used to measure how efficiently management uses shareholder’s funds to generate profit. while the Debt to Equity Ratio shows the balance between borrowed funds and owner’s investment. All these ratios play a crucial role for investors, lenders and creditors in making financial and investment related decisions.
Conclusion
In accounting, understanding the term equity is fundamental to evaluating the financial health of a company and make well informed business decisions. Businesses assess their equity on a regular basis to make strategies for growth, maintain financial stability and attract investment. In this article, we have discussed what is equity in accounting along with its types and components. We have also discussed the importance of equity and how you can calculate it with the help of a simple formula. We hope this article will be useful for you. You can also check our other account-related articles to get valuable information.