Equity in a financial world is a crucial concept and often has different meanings depending on the context. The most common type is related to shareholders’ equity.
It is calculated by using the business’s total assets value and subtracting its total liabilities. It shows the net worth of a company. Suppose the business has to go through a liquidation process; shareholder’s total equity is the amount of money to share between all shareholders.
Keep reading the article to figure out how shareholder’s equity works. Check some comprehensive examples to understand the formula better.
How does Equity Work?
Investors and analysts can easily interpret a company’s financial situation by comparing numbers that show its debts and the actual value of all assets.
It is also used as capital raised by the business. This capital helps purchase new assets, invest, and fund specific operations.
It’s possible to raise capital by issuing debt as a bonus or loan or by selling stock. Typically, investors look for equity investments since they offer better opportunities to share gained earnings from a business’s success and growth.
Equity is critical to investors since it represents their stake in the company. Having a share in a business means getting dividends and capital gains.
If shareholders own company equity, they get the right to vote during elections to the board of directors and for corporate actions. As a result, each shareholder gets ownership benefits that promote interest in the corporation.
There are two types of equity:
Positive type means that the corporation has sufficient assets to cover liabilities. The negative type shows a company’s increased liabilities compared to assets. It shows balance sheet insolvency if it’s negative for a long period.
It’s logical to assume that investors avoid investing in a business with negative equity. However, just measuring equity is not the only tool to determine a company’s financial health.
Stock Classes and Equity
Let us check standard stock ownership classes and how they are relevant to equity.
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It’s an asset of corporate ownership. If someone owns common stock, then they can get only residual equity when the main value is shared between preferred stockholders and creditors according to their shares. The majority of shareholders have common stock.
It’s also an asset of corporate ownership, but it’s shared differently. Preferred stock owners are also entitled to bigger shares. Overall, a preferred stock owner has certain advantages over common stockholders.
If a company is liquidated, preferred stock owners get paid before common stock owners. Ownership of preferred stock gives a better chance to get a bigger share of the equity.
Formula and Examples
To calculate equity, use the following calculation:
Shareholders’ equity – total liabilities = shareholders’ equity.
To complete the calculation, check the accounting balance sheet of the company. Then follow the instructions:
- Find the business’s total assets for the whole period.
- Find all liabilities; they are always listed separately on the balance sheet.
- Then follow the formula above and subtract total liabilities from the total value of assets.
It’s also possible to use a different calculation that requires adding a business’s share capital and retained earnings and then subtracting the value of treasury shares.
This method is less common even though the calculation shows the same results. Experts claim that the first method shows a clearer picture of the company’s financial health.
As for example, the simplest one is as follows:
A company has $1,200,000 in total assets and $500.000 in total liabilities. The total equity is: $1,200,000 – $500,000 = $700,000.
So, what is total equity, and how to calculate it? It requires subtracting total liabilities from total assets. Total assets include cash, accounts receivable, inventory, fixed assets, prepaid expenses, etc.
An accountant can find liability and assets on the balance sheet. Liabilities include accounts payable, short-term and long-term debts, etc. It’s possible to calculate everything on your own free of charge or ask the help of a professional accountant.
Author: Charles Lutwidge