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What is equity All you need to know

08 Feb 2024

Introduction 

Equity, also known as shareholder equity, is one of the most vital concepts in finance and business. It refers to the value of assets left with a company after all its liabilities are paid off. In simpler words, equity is the amount a company’s shareholders would receive if all its assets are liquidated and debts are cleared. It is displayed on the company’s balance sheet. As an investor, you can use this metric to evaluate a company’s financial health. It can help you judge the quality of a company’s financial ratios and make better investment decisions. Keep reading to learn more about equity meaning, its components and how it is calculated. 

What is equity?

Equity refers to the portion of a company’s assets owned by its shareholders. It includes capital invested in the company by purchasing stock and retained earnings. Equity is a vital component in a company’s balance sheet since it represents its financial soundness at a particular time. Additionally, it indicates a company’s financial stability and growth potential. Change in equity can also impact the value of a company’s shares. 

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Calculation of equity

You can calculate equity by subtracting a company's total liabilities from its total assets. You can gather all the information needed to calculate a company’s equity from its balance sheet. 

Here’s the formula to determine a company’s equity:

Shareholder equity = Total assets -Total liabilities

Equity can also be calculated as the value of share capital and retained earnings minus the value of treasury shares of a company. 

Example 

The financial details of a company XYZ are as follows:

Total assets = Rs. 15 lakh

Total liabilities = Rs. 6 lakh

To calculate the equity of company XYZ, you need to subtract its total liabilities from its total assets. 

Shareholder equity = Total assets - Total liabilities 

Shareholder equity = Rs. 15 lakh - Rs.6 lakh 

Shareholder equity = Rs. 9 lakh

Hence, the equity of company XYZ is Rs. 9 lakh. It implies that assets worth Rs. 9 lakh are available for the shareholders after all its liabilities are paid off. 

Components of equity

An essential financial metric, equity can have several components, such as common stock, preferred stock, retained earnings, etc. Let’s discuss each in brief:

  • Common stock: This is the amount of money invested in a company by its shareholders. 
  • Treasury stock: This type of equity represents the common stock a company has bought back from the investors. The company can re-issue these shares to shareholders when it has to raise funds
  • Preferred stock: This refers to the category of stock that has priority over common stock when it comes to dividend payment and asset distribution in case of liquidation 
  • Retained earnings: This type of equity is the portion of the net income not distributed as dividends but kept aside for reinvestment in the business. Retained earnings usually form the largest component of shareholder equity for a company operating for several years
  • Additional paid-in capital: This type of equity account represents the amount investors have paid for a company’s shares over and above their par value 
  • Accumulated Other Comprehensive Income (AOCI): AOCI refers to the special gains and losses not related to the company’s net income or loss. These are listed as special items in the balance sheet’s equity section

Conclusion 

Equity is a significant financial metric to gauge a company’s financial health. It can either be positive or negative. A positive equity indicates that a company has a sound financial standing. It reflects the company has sufficient finances to cover its liabilities and expand and grow. On the other hand, a negative equity indicates that the company’s liabilities are more than its assets, which can lead to balance sheet insolvency in the long run. Companies with negative equity are considered risky. However, a company’s equity is not the sole indicator of its financial health. You must use it with other metrics to accurately evaluate a company’s health and make more informed decisions. 

 

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