A Structured Guide to Understand “Equity” to Manage Business Finance

If you have an inclination towards understanding the basis of business and Entrepreneurship, then you must have heard of the term “Equity.” Let’s break down this important financial metric for beginners in a structured manner.

What is the Concept of Equity?

The term “Equity” speaks for the potential value that would possibly be returned to a company’s shareholders if in case all of the assets of a company are sold (liquidated) and after paying off all debts of the company.  

What is Equity in Business?

In business context, it refers to ownership value on an asset or business, after settlings all the liabilities of the company (if any).

Types of Equity:

Depending on the context, Equity can be of various types.

Owner’s Equity:

It represents the total investment that the owner of the business has invested in the business (subtracting all the liabilities) in case of sole proprietorships or partnerships.

This amount may increase if any additional investments are made or profits are gained and may decrease in case of any losses or withdrawals are made.

Shareholder’s Equity:

This type represents corporations where equity in form of “stocks” is owned by the shareholders or stockholders’ investment in the company. This equity consists of both amounts,

• Capital: that is invested by shareholders when they purchase a share of company.

• Retained Earnings: The collective earning of company which is reinvested in the business instead of being distributed among shareholder as dividends.

Home Equity:

This type represents the business of real estate. It is the total current value of a house excluding any outstanding dues and mortgages.

How is Equity calculated?

You can use balance sheet of a company’s finances to calculate equity using this simple equation.

Equity = (Total Assets) – (Total Liabilities)

What is an Example of Equity?

Suppose there is a business that has total assets worth $1,000,000 and total liability of the company is $250,000. Then the equity of that business using equity formula would be:

Equity = (Total Assets) – (Total Liabilities)

Equity = ($1,000,000) – ($250,000)

Equity = $750,000

If you want to calculate equity of a house that has the current market value let’s say $500,000 but there is still mortgage balance of $100,000 left to be paid, then equity of that house would be:

 Equity = (Current Market Value) – (Liabilities to Pay)

Equity = ($500,000) – ($100,000)

Equity = $400,000

What is the importance of Understanding Equity?

If you want to survive the unpredictable world of business, then it is better that you understand this economic evaluation tool. For businesses, having equity in positive figure is an encouraging indication that business has control over its finances and has enough assets to cover its liabilities, whereas negative equity of a business can be an alarming sign of a potential financial distress.   

How Equity can help Business owners in balancing business?

• It first and foremost determines the health of a business.    

• It shows the exact value of stakes (shares) of both business owner and shareholders in a business.

• Equity is the basis on which a business can raise capital, primarily by selling stocks. And Equity is that metric or tool that help investors or potential stockholders assess fundamental value and current financial health of a company before putting their money in that business.   

• In case of real estate, equity can be the basis which can be presented as collateral if a business is getting loan or in case of lines of credit.

Overall, if you want to dive into the world of business as an entrepreneur, stockholding investor, business partner or in any capacity, it is worth giving your time to properly understand “Equity” which is a business essential that can help both active business owner and investor in keeping an eye on financial health of business and then take decisions accordingly.