If you want to understand business finance, it’s important to understand the concept of equity. Equity is one of the most common ways to evaluate a company’s financial stability. Let’s look at how equity works, how it’s calculated, and the different types of business equity.
[Read more: Mastering Mobile Payments: Top Credit Card Payment Apps for Entrepreneurs]
What is equity?
Equity is the value of your business after deducting your liabilities from your assets. It’s the total amount of money that would be returned to your shareholders if your debt was paid off and your assets were liquidated.
If you run a corporation, it’s often referred to as “shareholder’s equity” since it refers to the shares of stock owned by your company’s investors. If you’re a sole proprietor or single-owner LLC, equity may be referred to as “owner’s equity.” Owner’s equity is used to determine a company’s valuation.
[Read more: Banks vs. Credit Unions: What’s the Difference?]
How do you calculate equity?
Equity is often included on a company’s balance sheet, and analysts often use it to evaluate a business’s financial health. Investors can look at equity to help them determine whether a company is worth investing in and can expand into new markets.
You’ll use the following formula to calculate equity:
Equity = Assets - Liabilities
Assets are a company’s resources, like cash, accounts receivable, or inventory. Liabilities include any debts the company owes, like loans, accounts payable, or payroll. A company’s assets and liabilities will be listed on its balance sheet, and once you subtract the liabilities from the assets, you’ll have shareholder equity.
[Read more: How to Find Your Small Business Credit Score]
Types of business equity
Let’s look at the most common types of business equity you’ll encounter.
Common stock
Common stock represents ownership in a company, and it gives shareholders the right to certain assets. Investors with common stock tend to have more control over the direction of the business. They may help determine company policies and have a say in who joins the board of directors.
Preferred stock
Preferred stock is similar to common stock, but these shareholders have fewer responsibilities, and less say in how the business is run. However, preferred stockholders can receive dividends and have the right to claim a company’s assets.
Equity is often included on a company’s balance sheet, and analysts often use it to evaluate a business’s financial health.
Treasury stock
Treasury stock refers to shares the business buys back from its investors. It’s usually reflected as a deduction from the company’s total equity, which usually has a negative balance.
Retained earnings
Your retained earnings account shows the business’s total earnings minus any dividends paid to shareholders. Retained earnings are the net income you didn’t pay out as dividends and can be used for investments.
What is equity financing?
Some startups choose equity financing to raise money without taking on business debt. With equity financing, business owners receive funding from an investor in exchange for a percentage of ownership in the company.
For example, let’s say you run an e-commerce business and need funds for additional inventory. You could give an investor 15% ownership of your business in exchange for the capital you need to expand your business operations. However, that investor now has a 15% stake in your company and has the right to contribute to all business decisions.
[Read more: How to Establish and Build Business Credit]
Examples of equity in real-world small businesses
Your business equity can change over time depending on your profits, losses, and financial decisions. For example, let’s say you start a coffee shop and invest $50,000 of your personal savings to get it off the ground. You use this money to purchase furniture, equipment, and the initial inventory. This investment will be recorded in your books as your initial owner’s equity.
In the first year, the coffee shop earns $120,000 in gross profits and incurs $70,000 in expenses for a net profit of $50,000. The business’s profit and your initial investment leave you with $100,000 in owner’s equity. If you reinvest that money in the business, your equity levels will remain strong.
But if you withdraw $20,000 for personal expenses, your equity drops to $80,000. And if you leave the money in the business but take on additional liabilities, like a loan, your equity will decrease.
Steps to grow your equity over time
Growing your business equity increases your company’s financial stability and future opportunities. Equity can be a valuable tool you can leverage to expand the company or attract new investors.
Increasing your company’s profits is the most straightforward path to improving your equity. For instance, you could grow your coffee shop’s revenue by adding a new product line or eventually opening a second location. Paying down business loans or lines of credit is another way to increase equity.
Finally, you also grow your equity by reinvesting your profits instead of withdrawing them. The more you invest in your business, the stronger its financial position will be. You can also work with your accountant to identify tax strategies that will help you save money and improve your equity position.
CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.
CO—is committed to helping you start, run and grow your small business. Learn more about the benefits of small business membership in the U.S. Chamber of Commerce, here.
