What Is Equity in Business? Here’s What You Need to know

When embarking on the journey of growing a business, it’s crucial to grasp the concept of equity. So, what is equity in business? This article will explore what you need to know about equity in business. 

What Is Equity in Business?

Equity in business is the value returned to shareholders once a company’s debts are paid off and its assets liquidated. Essentially, it is the difference between a company’s total assets and its total liabilities. As businesses expand, they often seek external funding from private investors, venture capitalists, or by going public. This results in multiple parties holding a stake in the business, each owning a portion of its equity.

Christina Morillo | Pexels | Businesses often seek external funding from private investors, venture capitalists, or by going public.

Understanding equity allows business owners and investors to evaluate the company’s success and stability. It serves as a key indicator of profitability and potential value for investors. For instance, if all liabilities are paid off and the remaining assets are distributed, the amount each investor receives depends on their ownership percentage.

The Components of Business Equity

1. Outstanding Shares: These are the shares that have been sold to investors and not repurchased by the company. They represent the total amount of shares owned by all investors.
2. Additional Paid-in Capital: This is the excess amount paid for shares over their nominal value at the time of issuance. It reflects the difference between the par value and the actual price at which the stock was sold.
3. Retained Earnings: This component represents the net earnings not distributed to shareholders as dividends. Instead, these earnings are reinvested in the business or used to pay off debt.
4. Treasury Stock: These are shares that the company has bought back from shareholders. Companies may repurchase shares to save for future use, such as funding new ventures or acquiring competitors.

Positive Equity vs. Negative Equity

Tima Miroshnichenko | Pexels | A company is considered to have positive equity when its assets exceed its liabilities, indicating profitability.

A company is considered to have positive equity when its assets exceed its liabilities, indicating profitability. Conversely, negative equity occurs when liabilities surpass assets, meaning the company owes more than it owns. However, negative equity doesn’t necessarily spell doom for a business. It can be a temporary state, often resulting from significant investments in assets like equipment or property.

How to Calculate Business Equity

Calculating business equity involves a straightforward formula:

Equity = Total Assets – Total Liabilities

To determine total assets, consider all owned property, cash, machinery, intellectual property, and other valuable items. Total liabilities include loans, taxes, salaries, and other obligations. Subtracting liabilities from assets gives the equity value.

Example Calculation:

Imagine a tech hardware manufacturer with the following figures:

• Inventory: $130,000
• Machinery and Equipment: $50,000
• Cash: $14,000
• Accounts Receivable: $60,000
• Total Assets: $254,000

Karolina Grabowska | Pexels | To determine total assets, consider all owned property, cash, machinery, intellectual property, and other valuable items.

And liabilities:

• Accounts Payable: $70,000
• Total Debt: $40,000
• Lease Obligations: $20,000
• Deferred Revenue: $80,000
• Total Liabilities: $210,000

The equity would be calculated as follows:

Equity = $254,000 (Total Assets) – $210,000 (Total Liabilities) = $44,500

Cost of Equity vs. Cost of Capital

The cost of equity is the return required by investors to compensate for the risk of investing in the company. It is typically higher than the cost of debt due to the greater risk involved. The Capital Asset Pricing Model (CAPM) is often used to calculate this cost.

On the other hand, the cost of capital encompasses both the cost of equity and the cost of debt. It represents the overall expense of financing business operations through various sources.

Managing Business Equity

Maintaining a healthy equity position involves diligent cash flow management to ensure liabilities are met as they come due. This practice supports financial stability, enhances investor confidence, and opens avenues for additional funding.