What Is Equity in Accounting?
Equity is best understood as the liquid value of a company. If a business went through liquidation at this moment, meaning all of its assets were liquidized and the debts the company owed were paid off, the equity would be the amount of money left over that would go to the stakeholders or owner.
Some people refer to equity as the "book value of a company." It provides an excellent way of examining the financial health of a company, as it makes clear how much money the organization generates and the value of its assets compared to the debt owed by the business. Investors often use figures like this when determining what to invest in a particular company.
Equity also becomes an important feature in calculations, such as return on equity (ROE), which can be used to measure a company's ability to generate profits compared to the value of the company. The calculation for ROE is net income divided by shareholders' equity.
The calculation for equity has many similarities to the net assets or net worth calculation. However, equity takes intangible assets, such as the brand's goodwill, into account. With the net assets or net worth calculation, you'll omit these factors and only use physical assets.
We'll help you understand how you can calculate your equity and the important factors you need to keep in mind as you incorporate it into your bookkeeping.
What Is Equity in Accounting?
Equity in accounting is the company's total assets minus its total liabilities. It determines the value of the company if it and all of its current assets were liquidated at that moment and all outstanding debts paid off.
Types of Equity in Accounting
Business owners should understand that there can be different categories of equity. Factors, such as the type of business you own, will determine the types of equity you need to consider when calculating your brand's equity. We'll review the main categories that you should familiarize yourself with.
For a sole proprietorship or partnership, the equity encountered is referred to as the "owner's equity." This equity describes the portion of the assets of the organization that the owner can personally claim.
For a corporation, the equity is referred to as the shareholders' equity. This refers to the corporation owner's (or owners') residual claim on the company's assets after the organization has paid off all debts. The shareholders are those who bought shares or stocks in the company as an investment to help the business raise funds.
When calculating shareholders' equity, you'll need to consider retained earnings. Retained earnings are the percentage of earnings that the company still has after they've paid out any earnings that go to shareholders as dividends.
Stockholders' equity is another term for shareholders' equity. The two terms refer to the same type of equity.
Private equity is how the equity of companies not publicly traded can be calculated. With these private companies, the market capitalization and market value of the equity are not as easily available.
Therefore, valuation calculations must be run by subtracting liabilities from the assets to find the book value. This can then be used to sell off private equity to investors in private placements, which allows these companies to raise revenue without being publicly traded.
How to Calculate Equity in Accounting
The "accounting equation" is used to determine the equity for a company. Although the equation isn't complicated, it does require you to have some information on hand. The equation is as follows:
|- Total Liabilities|
To run this equation, you'll need to know your total assets and total liabilities so you can subtract your liabilities from your assets. To find your total assets, you'll want to look for a variety of factors included on your company's balance sheet. For example, your cash, marketable securities, and accounts receivable will all count toward this total.
Similarly, your total liabilities will need to take different types of debt and liabilities into account. Accounts payable, long-term and short-term debt, and unearned revenue will all count toward your liabilities in this equation.
Remember that the purpose of this equation lies in its ability to determine the value of the company after all debts are paid. Therefore, taking any potential assets and liabilities into account is necessary to gain an accurate picture.
We'll now review common examples of assets and liabilities so you can better understand the types of items you need to look for on your balance sheets and financial statements to accurately run this calculation.
Assets can include a wide variety of items listed in your accounting books. It's not only actual money but also inventory and anything else that adds value to the business. Look for these types of items within your business's books:
- Accounts receivable
- Property, plant, and equipment (PPE)
- Patents (intangible asset)
- Marketable securities
- Accounts payable
- Short-term debt
- Notes payable
- Wages payable
- Interest payable
- Income taxes payable
- Customer deposits
- Warranty liability
- Lawsuits payable
Like assets, liabilities can include different types of line items, all of which include different debts that the business will have to pay at some point. Liabilities can include but are not limited to:
Now that you understand what equity is, it's important to go through the types of equity accounts that people can have with a given company. Equity can include but is not limited to:
- Common stock: Common stock is an initial investment in a business. Each shareholder has access to certain types of company assets. They might also have different responsibilities and privileges within the company, such as electing people for the board of directors or participating in the governing regulations of the business.
- Preferred stock: Preferred stock also describes a type of business investment. The difference lies in the rights of the preferred stock owners. These equity holders don't have as many responsibilities toward the company, nor do they have voting rights. They can also receive dividends from the company.
- Paid-in capital: Paid-in capital refers to any additional funding that investors paid on top of the par value of the shares they bought. Some also refer to this as "contributed surplus."
- Retained earnings: The retained earnings are the funds that your business builds after subtracting the dividends that needed to be paid to shareholders.
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Notice to the Reader
The content within this article is meant to be used as general accounting guidelines and may not apply to your specific situation. Always consult with a professional accountant to ensure you're meeting accounting standards.