Equity Explained for Dummies

What is equity?

In accounting, business, and finance, equity refers to the value attributable to the owners of a business, such as a company.

Put differently, equity represents the value of ownership in something, for example, a business.

The Cambridge Dictionary defines equity in business as follows: ‘The value of a company, divided into many equal parts owned by the shareholders, or one of the equal parts into which the value of a company is divided.’

Equity in companies

The value attributable to shareholders in a company is referred to as shareholders’ equity (with regard to publicly held companies) and owners’ equity (concerning privately held companies).

Shareholders’ or owners’ equity is the amount of money that would be paid to a company’s shareholders if all the assets were converted into cash (liquidated) and all of the company’s debt was repaid.

Generally, shareholders’ equity is determined in two ways:

Book value of equity

The formula to calculate the book value of equity is:

Book value equity = Assets – less Liabilities

The book value of equity is always used in accounting. The formula is a rearrangement of the accounting equation (Assets = Liabilities + Equity)[1]. The accounting equation is also known as the balance sheet equation or the fundamental accounting equation.

Assets of a company comprise the following types of assets:

• Current assets such as cash and cash receivables, accounts receivable, inventory, and prepaid expenses.
• Non-current assets (fixed assets) like vehicles, property, plant, and equipment (PP&E), and computer equipment.
• Intangible assets, for example, goodwill, patents, and trademarks.

Liabilities of a company include liabilities such as:

• Current liabilities like accounts payable (creditors) and short-term loans. Typically, current liabilities are payable within twelve months or less.
• Non-current liabilities include long-term loans, bonds payable, and lease obligations.

Equity of a company as indicated on its balance sheet

The book value of equity is the equity that an accountant calculates when preparing the financial statements of a company. Typically, equity is indicated as share capital, plus retained earnings, plus profit (loss) (for the given accounting period) on the balance sheet.

• Share capital

The following accounts are added together to calculate the sum of the share capital:

• Share capital, also called equity capital, refers to money paid by investors to buy shares (ordinary or preference shares) in a company. Share capital is the main source of funds for a company.
• Contributed surplus, also referred to as additional paid-in capital, is the amount of capital that exceeds the par value when shares are issued to investors.
• Retained earnings

Retained earnings are the portion of a company’s profit that is retained (held) for future use.

• Net income/ (Net loss)

Net income, also called net profit or net earnings, is the total income of a business minus all the expenses, interest, and taxes for a given accounting period.

A net loss occurs when the expenses of a business exceed the total income for a given financial period. A net loss reduces the retained earnings of a company.

If a company issues dividends during a financial period, the amount of dividends reduces the retained earnings or profit of the company.

Market value of equity

In finance, equity is expressed as a market value. The market value may be higher or lower than the book value. The two values differ because book value equity is a backward-looking calculation, while the market value equity is a metric that is calculated to estimate what the future performance of a company’s share capital will be.

The market value equity, also referred to as the market capitalisation of the company, of a public traded company is calculated by multiplying the latest share price of the company with the total number of outstanding shares.

Regarding private companies, it is much more difficult to determine the market value equity. Methods that can be used for evaluating private companies include:

• The comparable company analysis (CCA)

This is the most common method to value the market value equity of a private company. The CCA method compares the valuation ratios of a private company to the valuation ratios of public companies of relatively the same size and with related business operations.

• The discounted cash flow (DCF) method

The DCF method estimates the revenue growth of the private company by averaging the revenue growth rates obtained from similar public traded companies.

Bear in mind, whatever the method used to determine the private company’s market value, also known as net worth, all the calculations are based on estimations and assumptions, potentially providing an inaccurate valuation.

Accounting ratios involving equity

In accounting, there is a variety of ratios in which equity is used:

Equity ratio

The equity ratio, also called shareholder equity ratio and expressed as a percentage, measures how much of a company’s assets have been funded by equity shares issued, rather than using debt.

The lower the ratio, the more debt is used by a company to acquire assets, exposing the company to more debt risk. Put in other words, the closer the ratio result is to 100%, the more share capital a company has used to acquire and finance its assets, instead of debt.

The equity ratio is an indication of how leveraged a company is, meaning how much debt a company uses to finance its assets.

The formula to determine the equity ratio is:

Equity ratio = Total equity/Total assets

Example of the equity ratio:

Company MBP’s total assets are valued at R500 000, while its shareholders’ equity amounts to R350 000.

MBP’s equity ratio = R350 000/R500 000

= 0.70

= 70%

The equity ratio of 70% indicates that company MBP has financed 70% of its assets with shareholders’ equity, implying that 30% of its assets are funded by debt.

Put in other words, if MBP liquidated all its assets and repay all its debts, there would be 70% left of the company’s financial resources for the shareholders.

Debt-to-equity ratio

The debt-to-equity ratio (also referred to as the risk ratio or debt-equity ratio) is used to determine a company’s financial leverage. Express differently, it is a leverage ratio that weighs the total debt of a company against total shareholders’ equity.

It is a ratio that shows whether shareholders’ equity will cover all outstanding debts when a company is dissolved.

The formula for the debt-to-equity ratio is as follows:

Debt-to-equity ratio = Total debt/Shareholders’ equity

Where total debt includes short-term and long-term debt.

Example of debt-equity ratio:

The balance sheet of company A shows total debt to the amount of R300 000, and the total shareholders’ equity is worth R850 000.

Debt-to-equity ratio = R300 000/R850 000

= 0.35

The risk ratio of 0.35 implies that for everyone South African rand (ZAR) in shareholders’ equity, company A uses 35 cents in debt. In other words, the company has 35 cents in leverage or a debt level of 35% of equity.

A ratio of 1 means that debt providers (lenders and creditors) and shareholders equally provide financing for the assets of a company.

The general concensus is that a ratio of 2 or less is acceptable. However, the most favourable debt-to-equity ratio has to be evaluated in terms of the industry in which the company operates and according to requirements applicable to the particular company.

Return on equity (ROE)

Return on equity (ROE) is a profitability ratio, expressed as a percentage, that calculates the profitability of a company in relation to its shareholders’ equity.

Express differently, ROE measures a company’s ability to generate profits from its shareholders’ equity, indicating how much profit each South African rand (ZAR) of ordinary shareholders’ equity generates.

The higher a company’s ROE, the better its ability to generate profits.

It is an important ratio for ordinary shareholders.

Formula for calculation of return on equity (ROE):

ROE = Net income/Shareholders’ equity

Where:

• Net income (net earnings) is the amount after the deduction of taxes. If applicable, dividends on preference shares are excluded.
• Shareholders’ equity is ordinary shareholders’ equity. The average shareholders’ equity for a given financial period is used.

Example of a company’s ROE:

The following financial information from company BAB is available from its financial statements for the past financial year:

• Ordinary shareholders’ equity: At beginning of financial year – R275 000; at the end of the financial year – R300 000.
• Net income after taxes – R445 000.
• Preference shares dividends issued: R15 000.

Company BAB’s return on equity is calculated as follows:

ROE = (R445 000 – R15 000)/ ((R275 000 + R300 000)/2)

= R430 000/R287 500

= 1.50

= 150%

Company BAB’s return on equity (ROE) of 150% shows a 150% return for ordinary shareholders on their investment. Put differently, everyone South African rand (ZAR) earned R1.50 for the financial year.

Personal equity

The concept of equity is also applicable to individuals. Personal equity, commonly referred to as net worth, refers to the difference between a person’s assets and his or her liabilities.

Personal assets comprise, among others, the following assets:

• Cash
• Cheque and savings accounts.
• Money market accounts.
• Different types of investments such as shares in public traded companies.
• Real estate, including residential (home) and commercial (warehouses) real estate.
• Vehicles, such as cars, trucks, and motorcycles (motorbikes).
• Household furniture and other household items.

Examples of personal liabilities include:

• Credit card balances (if not paid in full each month).
• Personal loans.
• Outstanding bills (utilities, cell phone).
• Outstanding taxes.
• Mortgages.
• Student loans.
• Auto loans (car loans).

Negative equity

Businesses and individuals face the risk of negative equity.

Some examples of negative equity are:

• Negative shareholders’ equity occurs when a company incurs losses that exceed the sum of payments made to shareholders and retained earnings from prior accounting periods.

Reasons for a company’s negative equity include accumulated losses over time, combined with excessive debts incurred to cover the accumulated losses, and considerable dividend distributions that have depleted the company’s retained earnings.

• Negative personal equity refers to a situation when an individual’s liabilities exceed his or her assets. In other words, a person could sell all of his/her assets and collect all the money owed to him/her, and he/she still would not be able to repay all his/her debts.

• Examples of negative equity regarding assets

• Real estate property equity is calculated by deducting the outstanding balance on the mortgage from the current market value of the property. If the outstanding balance on the mortgage exceeds the current market value of the property, the property has a negative equity.

• If a person owes more on his/her auto loan than the vehicle is worth, then he/she has a negative equity, meaning if the person tries to sell the vehicle, he/she would not be able to collect the amount that he/she already owes on the vehicle. For instance, if the balance on the auto loan is R70 000 and the vehicle is sold for R65 000, that means the person has a negative equity of R5 000 with regard to the vehicle.

Variations on equity

In addition to shareholders’ equity and personal equity, there are also other forms of equity:

• Equity in margin trading is the value of securities in a margin account with a broker or brokerage minus what the margin account holder owes the broker or brokerage.
• Brand equity, also called intangible equity, refers to the level of influence a brand name (like Apple, Coca-Cola) has in the minds of consumers and the value premium that a company generates from an identifiable and well-known name when compared to a generic equivalent.

Intangible equity is built up through many years of excellent products and service to the customers.

Awareness and experience are the two key principles of brand equity.

[1] See the article, ‘The Accounting Equation Explained for Dummies,’ for a detailed explanation of the accounting equation.