Almost everyone understands home equity – this private equity is the percentage of your home that you own after paying off your mortgage. More technically, it is the value of an asset, such as real estate, minus the liabilities, such as debt.
But the term “equity” also applies to things like companies. As a business owner and australiabusinessblog.com, you need to know how equity affects your ventures and how to calculate it for your shareholders, especially before going public. This article discusses in detail how to calculate shareholder equity.
How equity works
Equity is the value of an asset without its liabilities.
Let’s say you own a commercial building, such as a storefront, worth $500,000. You paid $300,000 of that property’s mortgage, leaving you with $200,000 plus interest in liabilities. So the equity in the property is (approximately) the $300,000 you own from the building.
This is of course a basic example. You can search and calculate equity in everything from basic assets to business ventures and stock portfolios. Either way, equity is essential so that investors, shareholders and other interested parties can determine the true value of an asset.
Related: How to Safely Tap into Your Equity in a Financial Emergency
Equityis therefore the net worth or total dollar value of the company that would be returned to stockholders of the company’s stock if:
- The company’s assets would be liquidated.
- The company’s debts had to be paid off.
Simply put, equity is the total amount of equity left over that shareholders would have to distribute among themselves if a company were to be fully liquidated to settle any outstanding debts.
You can also think of equity (or SE) as the owners’ collective residual claim on the company’s assets, after outstanding debts have been paid. Shareholders’ equity is the same as a company’s total assets minus its total liabilities.
It is essential to know how to calculate the share equity for several reasons:
- Investors and analysts may need to determine a company’s market value and make appropriate equity investments.
- A company’s board of directors can use this information to accurately determine the company’s valuation for financial statements.
While similar, equity is not the same as liquidation value. The liquidation value of the company is affected by the asset value of physical items such as equipment or inventory.
Related: Debt vs Equity Financing: Which Way Should Your Business Go?
Here is an example of equity:
Imagine you own Company A, with total assets of $3 million. You have total liabilities of $1.2 million. If the company were liquidated and the assets became $3 million, you would use some of that money to pay off the $1.2 million in liabilities.
What does that leave to shareholders? About $1.8 million.
Which components are included in equity?
For any company, equity can be made up of many different components. These include:
- Equity components, such as common stock, preferred stock, and treasury stock.
- Retained earnings — this is the percentage of net earnings that is not (yet) distributed to shareholders as dividends.
- Unrealized gains and losses.
- Contributed capital.
- Physical assets such as business equipment and products.
When calculating shareholders’ equity using either of the two formulas below, it is essential to add all of these components together when calculating a company’s total asset value.
Related: Use a balance sheet to evaluate the health of your business
Positive versus negative equity
Things can even get a little more complicated. There are positive and negative types of equity.
Positive equity means that a company has enough assets to cover its debts or obligations. Negative equity, on the other hand, means that a company’s liabilities exceed its total asset value.
If a company’s equity remains negative, it may appear insolvent on its balance sheet. In other words, the company could not liquidate itself and all of its assets and still pay off its debts, which could create financial problems for investors, shareholders, business owners and executives.
Many investors view companies with negative equity as risky investments. While equity isn’t the only indicator of a company’s financial gap, you can use it in conjunction with other metrics or tools. When used with those tools, investors and potential shareholders can get a more accurate picture of the financial health of almost any company.
While retained earnings are an essential part of shareholders’ equity (since the current percentage of net income is not paid to shareholders as dividends), they should not be confused with liquid assets such as cash. You can use several years of retained earnings for assets, expenses, or other purposes to grow a business. It is not currently “realized” cash.
Fortunately, calculating shareholder equity is relatively easy. Remember that equity is just the total asset value of the company minus the liabilities. You can calculate equity using the information on a company’s balance sheet.
Here’s the formula:
Equity = total assets – total liabilities
Also called the balance sheet or accounting equation, the equity equation is one of the most critical tools in analyzing the health of the company.
Here’s how to calculate equity step-by-step:
- First, determine the company’s total assets on the balance sheet for a specific period, such as one financial year. Add up all these assets properly and correctly or use an up-to-date balance sheet.
- Then add up all the total liabilities. Any up-to-date balance sheet must contain this information. Liabilities include debts and outstanding charges.
- Next, determine the total equity and add that number to the total liabilities.
- The remaining assets must be equal to the sum of total equity and total liabilities.
A note on calculating total assets includes both current and non-current assets. If you don’t know, current assets are any assets that you can convert into cash within one financial year.
This includes cash, inventory and accounts receivable. Long-term or long-term assets that you cannot convert to cash in the same time frame, such as patents, property, and plant and equipment (PPE).
A note on calculating total liabilities: Liabilities also include both current and non-current liabilities. Consistent with the above, current liabilities are all debts due within one year, such as bills to be paid or outstanding taxes.
Long-term debt is any debt or other obligation that is due more than one year in advance, such as leases, debentures and pension obligations.
Related: How to protect your personal finances from business risks
The above equity formula should serve you well in most cases. Yet there is a secondary formula that can also be useful.
Here is the secondary formula:
Equity = share capital + retained earnings – treasury
This “equity capital method” for calculating equity is also known as the investor equation. This formula sums up all of a company’s retained earnings and share capital, then subtracts treasury shares.
The retained earnings in this formula are the sum of a company’s total or cumulative earnings after they pay dividends. Most shareholders receive balance sheets that show this number in the “equity” section.
This formula can give a slightly more accurate picture of what shareholders can expect if they are forced/decided to liquidate or exit a company. However, you can use either formula equally well to calculate shareholder equity.
Equity is essential for shareholders for several reasons.
For starters, equity tells you the total return on investment versus the amount invested by equity investors.
Ratios such as return on equity, or ROE (the company’s net income divided by equity), can be used to measure how well a company’s management team uses investor equity to generate profits. ROE can tell investors how skilled current executives are at attracting investment funds and turning them into more money.
A company with positive equity has enough assets to cover its liabilities. In an emergency, shareholders or investors could theoretically get out without incurring significant financial losses.
As mentioned earlier, you can also use SE with other financial metrics or ratios to accurately determine whether a company is a wise investment.
These statistics include stock price, capital gains, property values, total company assets and other vital elements of private companies. Because equity is essential for shareholders, it is also crucial for business owners and board members to convert.
In addition, equity affects the value of startups on the stock exchange. Appropriate asset allocation will help companies grow, resulting in a higher amount of money from stock buyers and ETF managers.
Return on equity in detail
Here’s a deeper dive into it return on equity. Analysts and investors use this measure to determine whether a company is using stock or investment resources to efficiently and effectively make a profit.
Let’s say you have a choice to invest in a company and want to see the return on equity before making a decision. You look at the company’s balance sheet and you find out that the return on equity is 12% and has been at 12% for years.
Related: Debt vs Equity Financing: Which Way Should Your Business Go?
That’s a pretty good return on any investment. It may indicate that the company is worth putting your own money into.
On the other hand, if the return on equity is low, say 1%, and a company’s current equity is negative, this is an undeniable sign that your investment dollars will be worth more if you invest them elsewhere.
Calculating equity is essential when proposing investors for more funding and advising your shareholders. Now you know how to calculate shareholder equity using two different formulas.
Looking for more resources to expand your professional financial knowledge? Check out the guides to money and finances for entrepreneurs here