The promoters start a company with their own money. They can also raise funds by taking the public’s money by giving them part ownership and/or borrowing some money from friends, relatives, banks and other financial institutions. In general, these are the sources of funds for any company at any given point of time. Technically, they are called equity and debt.
Equity represents the portion of funds that is contributed by the owners. Here, there is no distinction between the promoters who founded the company, subsequent owners if any other person acquires shares of the company and the part owners who subscribe to the shares through capital markets. On the other hand, debt represents that portion where the ownership does not dilute. The lenders charge interest instead. Therefore, this is also referred to as external liabilities.
Let’s understand what equity is all about.
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What is equity?
In simple terms, equity represents ownership in a business. It is the amount that would be returned back to the shareholders after the assets of the company are liquidated and all the debts are paid off.
Equity: All You Need to Know!
- Equity represents ownership in a business or how much money the shareholders have put into the business.
- It is not restricted to the amount contributed or raised by owners and shareholders but also the undistributed profits and the amount parked for specific purposes.
- It is the value that shareholders get after the debts are paid off in the case of liquidation. Therefore, it is a liability of the company. That’s why we see it on the liabilities side of the balance sheet.
- Equity is different from a bond, private equity, and equity fund.
- Equity also called shareholder’s equity, is calculated by subtracting the external liabilities from the total assets.
How does shareholder equity work?
Equity also called shareholder’s equity, represents the amount shareholders have invested in the business. Companies use this equity to buy assets, grow and expand production.
Equity ownership gives investors the right to receive dividends if the company makes a profit. Also, in a few cases, they may be entitled to voting rights in the company’s managerial decisions.
Formula and how to calculate shareholders’ equity?
This is a basic balance sheet structure –
| Equity and Liabilities | Assets |
| Equity | Non-Current Assets |
| Non-Current Liabilities | Current Assets |
| Current Liabilities (Add a common bracket for Current and Non-Current and mention “Also called as External Liabilities”) | – |
| Total Equity and Liabilities | Total Assets |
If we want to calculate shareholder’s equity from a financial statement, then the formula is as follows –
Shareholder’s equity = Total assets – External liabilities
Shareholder’s equity, net assets and net worth are usually used interchangeably. It shows the financial standing of the company. The company’s assets are sufficient to cover its liabilities if the amount is positive. The amount can also turn negative. If the company has considerable debt and its value of assets falls, then we can see negative equity. It may also happen if the company has not repaid its loan and is unable to repay (i.e. the value of external liabilities keep on rising). Usually, in these cases, the company may lead to insolvency.
What are the components of shareholder equity?
The components of the shareholder’s equity are as follows –
- Total assets, which include fixed assets, investments, receivables, etc.
- External liabilities, which include creditors, outstanding payments, debts borrowed, etc.
You can also calculate the shareholder’s equity using an alternative formula which is as follows –
Shareholder’s equity = share capital + reserves and surplus
If using the alternative formula, shareholder’s equity would include the following components
- Share capital which would include equity and preference share capital
- Reserves and surplus mean the profits retained by the company to fund business growth or the part of the profit that is not distributed as dividends.
Use Tickertape’s Stock Screener to find the total equity of a company. Open the Stock Screener and search for ‘Total Equity’ in ‘Add Filters’.
Example of shareholder equity
To understand the calculation of shareholder’s equity, look at the following balance sheet –
| Particulars | Amount (in Rs. cr.) | Particulars | Amount (in Rs. cr.) |
| Share capital | Rs. 1,500 | Fixed assets | Rs. 1,000 |
| Reserves and surplus | Rs. 100 | Debtors | Rs. 300 |
| Loan | Rs. 200 | Receivables | Rs. 50 |
| Creditors | Rs. 150 | Investments | Rs. 500 |
| Accounts payable | Rs. 50 | Other assets | Rs. 150 |
| Total | Rs. 2,000 | Total | Rs. 2,000 |
Shareholder’s equity = Total assets – Total liabilities (loan + creditors + account payables)
= (Rs. 2,000 – Rs. 400) = Rs. 1,600 cr.
Alternatively,
Shareholder’s equity = share capital + reserves and surplus
= (Rs. 1,500 = Rs. 100) = Rs. 1,600 cr.
Other forms of equity
Equity can also be depicted in other forms –
- The stock of the company is also called equity. It is called equity share and/or preference share.
- If the business files for bankruptcy and liquidates, equity would mean the amount left after paying off all the liabilities. This equity is called ownership equity.
- Although the term is largely used in the context of a company, we can apply for individuals or families too. It would suggest your own capital. Let’s say you only have Rs. 1 lakh in cash and a house worth Rs. 15 lakh; then your own capital is Rs. 16 lakh assuming you have not mortgaged your house. If you have borrowed Rs. 5 lakh, then the equity will be Rs. 11 lakh (16 less 5).
What is private equity (PE)?
Many companies usually approach private equity firms for their capital needs. As discussed earlier, a company can approach banks or the stock market to raise funds. But in this approach, the company raises funds through a few investors instead of the stock market. Therefore, private equity is generally referred to as capital investments in companies not listed on the stock exchange. These investors get part ownership in the company. The capital contributed by such investors forms the company’s equity capital, and these investors are also involved in decision-making. PEs usually sell their stake when the company decides to go public (i.e. listing).
Types of private equity financing
Private equity can be financed in the following ways –
- Through venture capitalists who invest in a start-up in exchange for a minority stake holding in the business
- Through a Private Investment in a Public Company (PIPE). In this type of financing, the shares of a company are offered at a discount to their current market value.
- Through investment by accredited investors.
Equity vs return on equity
While equity denotes the ownership in a business, Return on Equity (ROE) is a ratio that measures the financial performance of a business. ROE is calculated using the following formula –
ROE = Net income / Shareholder’s equity
In simple terms, it means how much profit the company has earned with respect to each rupee invested by the shareholder. Since shareholder’s equity is also called net assets, ROE is also termed as the returns that shareholders get on the net assets of the business. It denotes the efficiency of a business in using its assets to generate profits.
Use Tickertape’s Stock Screener to get the ROE of a company.
– Log in to Tickertape
– Launch the Stock Screener
– Click on ‘Add Filter’
– Search and select ‘Return on Equity’
What is equity in finance?
In accounting, equity means the shareholder’s equity, i.e., the difference between the total assets and the total liabilities.
Equity also represents the company’s net worth and is used as a metric by investors when making investment decisions.
What are some other terms used to describe equity?
Other terms that describe equity include the following –
- Shareholder’s equity
- Share capital
- Net asset value
- Book value
- Net worth
How is equity used by investors?
Equity can serve as an important metric for making investment decisions. Investors might check the shareholder’s equity of a business before investing in it. They would benchmark the shareholder’s equity and then ascertain whether the stock’s purchase price is justified by comparing the book value per share. Book value per share is nothing but total equity divided by the number of equity shares issued by the company.
For instance, if the book value per share is Rs. 10 and the stock’s market price is Rs. 12, investors might not invest in the company since they would be losing Rs. 2 in the case of liquidation. It also means that this company’s shares are overvalued. However, if the market price is lower than the shareholder’s equity, the investors are prompted to invest in the business as they know that the company’s assets would cover their investment in the case of liquidation. It also means that they are undervalued.
What is the difference between equity and debt?
Both equity and debt are sources of raising funds for the business. However, both these modes are considerably different from one another. The differences are as follows –
- Equity involves dilution of ownership. The same is not the case for debt.
- In the case of equity, dividend payments are made, which may not be compulsory. Debt involves a regular interest payment.
- Equity entitles investors to a voting right. This is not applicable to debt.
- Equity investors are paid at the end after debt investors are paid off in the case of liquidation
Conclusion
Equity is an important source of financing for businesses looking to expand. A business can opt for private funding before listing itself in the market or can list itself by offering its shares to the public. Before investing in equities, understand what equity is and what it entails. Study the equity ratios of a company before investing so that you can pick the right company to invest in.
