Defining and Explaining Equity, and What it Means for an Organization
- Acumen Learning
- May 20, 2022
- 4 min read
Updated: Nov 14, 2022
What is Equity? You've probably heard the term before, but what does it mean? And ... maybe more importantly, what can it tell you?
If you're looking for a simple definition, equity is the portion of the company that its shareholders actually own. On a balance sheet, this will include things like common equity and retained earnings - two of the most important numbers that you'll see in the equity section of a balance sheet.
Common equity means that the organization has investors that own part of the company, and
retained earnings are an accumulation of all of the income that the company has earned since its inception that they haven't given back to investors.
So, theoretically, equity is the amount of money that the business owners (i.e. shareholders) would get back if all of the assets of the company were liquidated, and all of the debts were paid off. The equity portion would be whatever is left over after all of those debts were paid off, so the amount that shareholders actually own. Other common words used to refer to equity include net worth, book value, or owner's equity.
If your organization is looking to grow its equity, there are two major ways that you (yes, I'm talking to you) can help!
First, you can grow profits, which will be found in the retained earnings portion of the equity section. How do you grow profits? Well...sell more!
The second thing we can do is to pay down the company debts. Now, if you're not in accounting or finance, you might be thinking to yourself, I can't pay down debts! BUT, you are responsible for driving the cash flow that will in turn cover this debt. For example, if you can make the decision to use a less costly, but comparable widget that won't impact quality - do that! It'll drive costs down and free up more money to pay down that debt.
For accounting purposes, equity can be measured by subtracting liabilities from the value of the assets. Sounds simple enough, but let's break it down even further. To review, a liability is a debt or other legal financial obligation that binds a company for payment. Examples of these include employee salaries, rent, mortgages, loans - basically anything that a company is required to payout. An asset, on the other hand, is any resource that is owned or controlled by the company for its business operations, such as property, inventory, cash, patents, products, and more.
Here is an example of equity personally that you're likely familiar with...
If I wanted to buy a $500,000 house and was able to make a down payment of $100,000, I would need a bank loan to cover the rest of the cost, so for $400,000. This means I have $100,000 in equity in my home, or I own 20% of it. If your home's value increases, as many homes are now, your equity will also increase. Also, as you pay down your bank loan, your equity will increase as well.
Similar to your personal finances, you can keep track of a company's equity and financial strength by looking at its balance sheet. If you're not familiar with it, a balance sheet is a financial statement that reports a company's assets, liabilities, and shareholder equity at a specific point in time. Equity is listed within the third section of a balance sheet, sometimes called stockholder's equity or owner's equity. It summarizes a company's equity position and looks at the shareholder's value in the company.
To better understand, let's look at the balance sheet of a large corporation.
Google (Alphabet Inc.) has $359B in total assets, this includes inventory, equipment, buildings, cash and cash equivalents, and more. Remember, it's essentially anything of value that Google owns or controls. It also has $108B in total liabilities or debt - the amount that Google owes. $359B minus $108B leaves you with a total shareholder equity of $251B. So how financially strong is Google? Are they able to meet their obligations? One way to determine that is by using the equity ratio.
An equity ratio is a financial ratio that determines how much of company resources (assets) are funded by equity as opposed by liabilities. The Fortune 500's average equity ratio in 2021 was 20%. An equity ratio lower than 50% indicates that a company's assets are primarily funded by debt while an equity ratio higher than 50% means investors, rather than debt, are currently funding more assets. Healthy ratios depend on the industry, but by using the equity ratio formula, we can determine that Google has about a 70% equity ratio.
See...it isn't as complicated as we thought! Having the knowledge of Business Acumen is helpful when learning these common phrases. Equity is a word that is thrown around so much, but there are a number of people that may have no idea what it means! So go take a look at your company’s balance sheet and determine how financially strong your company is.
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