In finance and accounting, equity is the value attributable to the owners of a business. The book value of equity is calculated as the difference between assets and liabilities on the company’s balance sheet, while the market value of equity is based on the current share price (if public) or a value that is determined by investors or valuation professionals.
In simpler terms, a company’s financial position is based on its assets, liabilities and total equity. Assets are everything the company owns. Liabilities are everything the company owes to others. Equity simply refers to the net income of a company that has not been withdrawn by the owners. The accounting equation of a company is that its assets subtract its liabilities equals its total equity.
If a company decided to use all of its assets to pay off its current and long-term debts, the remaining amount would be its equity balance. Often referred to as a company’s net worth, the equity balance may be affected by gains and losses from operations and investments, accounting changes and adjustments, the payout of cash dividends and other equity transactions.
For instance, when you buy inventory, you spend your cash assets on inventory assets. If you’ve spent your money prudently, the value of the inventory you buy is equal to the value of the cash you spent on it. So when you mark up that product from the wholesale to the retail price and sell it for more than you paid, you usually earn money and add to your company’s equity.
Therefore, this increase in equity will depend on controlling indirect costs such as sales labour and rent on your shop. Note that if these expenses exceed the margin between what you paid and what you charge, then your business will lose money, and the transaction will ultimately show up on your balance sheet as a decrease in equity.
Meanwhile, increase in equity from a company’s earnings activities are more or less likely to occur when your company creates an outcome that is greater than the sum of its parts, through creativity or savvy.
Intellectual property, particularly, may take few tangible or measurable resources to develop relative to the value that it can generate. Indeed, research and development can be costly and deplete company assets, at least in the short term. But if your idea is successful, you can enjoy long term rewards from your initial investment.
Types of Transactions That Affect Equity in Business
The equity of a business represents the total value of the company to its owners. Total equity is calculated using the accounting equation of assets minus liabilities equals equity. Have it in mind that this calculation can be used to analyze which transactions affect the equity of a company.
If the equity number is negative, for instance, there is no equity and the business is in the red. Nonetheless, there four major types of transactions that affect equity in a business. They include;
-
Owner Withdrawals
Withdrawing cash from a business will indeed cause a reduction in the company’s assets resulting in lower equity. This is different from using cash to buy inventory or equipment. In this case, the cash would be replaced by a company asset of equal value on the financial statement resulting in equity staying the same. Since funds are taken out of the business, its equity will lower.
But if an owner puts money into the business, this will add cash on the assets side of the accounting equation, but it will add a corresponding liability if the capital infusion goes onto the balance sheet as a debt, or a sum that the business must formally repay. If there is no formal repayment arrangement, the sum won’t appear as a liability. Instead, it will show up as owner’s equity – because cash assets increase, while liabilities do not.
-
Investment of Capital
Note that if new funds are added to a company by its owners, the company’s equity will increase. Normally, this can be done by adding more investment by the current owners or by selling new shares of the business to other investors. This investment raises equity as it gives more cash, higher assets, to the company without taking an additional liability. Also note that this contrasts with raising money with a bank loan. The asset of cash from a loan is matched by the liability of the loan resulting in no impact on equity.
-
Advertising
Have it in mind that money spent on advertising will cause an initial reduction in equity. Paying for advertising costs cash out of a company’s assets. Note that unlike buying equipment, which gives an immediate new asset, advertising gives a future economic benefit.
A future benefit cannot be measured according to accounting principles and cannot be listed as an asset by a company. As the advertising brings in new income to the company, its equity will then rise accordingly. At the beginning, an investment in advertising will lower a company’s equity.
-
Business Transactions
Just like it was stated above, assets minus liabilities equal equity. In other words, the equity or value of your business can be measured by subtracting what you owe from what you own. According to this equation, virtually every transaction that your business makes has an impact on equity.
Sales earn money and add to your assets, while expenditures often deplete assets and increase liabilities. Additionally, a company’s value can also increase or decrease because of transactions and events that are neither linear nor measurable.
Note that you may receive favourable or negative publicity that increases demand for your products or your stock, adding to their value and consequently to the value of your business. Or your equipment may depreciate on paper, despite being in perfectly good working order, diminishing the accounting value of an asset that retains its value for your business because it’s still perfectly useful.
Conclusion
In the world of business and finance, equity refers to the value of ownership in something. Equity can be used to measure the value of an entire business, a single stock issued by a business, the inventory owned by the business, or any other thing that has value.
Equity takes debt and other liabilities into account, and equity can be negative when the debt tied to something outweighs that thing’s value. Equity can also account for intangible assets, such as reputation or brand identity.