Equity represents the amount of money that would be returned to a company’s shareholders if that company were to liquefy its assets, pay off its debts, and distribute the remainder of its capital. More generally, equity can be thought of as a degree of ownership of an asset after subtracting all debts associated with it. Equity is recorded on a company’s balance sheet along with assets and liabilities. To determine a company’s equity, just take the sum of their assets and subtract the sum of their liabilities.
The primary way a company increases its equity is by selling shares of the company on the stock market. Stock, along with bonds, are known as securities. Companies sell securities as a way to raise capital to further finance business operations, aside from the income made from regular business operations. While investors buy bonds in order to profit off of interest payments, buying shares provides repayment in the form of a degree of ownership over a company. Shareholders also sometimes earn a profit through dividends. Companies that make a particularly large income, such that they have no reasonable way to use all of their income to expand business, may choose to distribute a portion of leftover cash to its shareholders as dividends. The amount of equity a company has left after paying its investors dividends is known as retained earnings. Retained earnings is an important figure for investors, especially long-term investors, since it effectively represents a company’s savings. It’s the cumulative total of a business’s profits that have been put aside to use later. Retained earnings counts directly towards equity; the larger a company’s retained earnings, the more money will be returned to investors in the event of bankruptcy; and in the event that the company does not go bankrupt, more retained earnings allow the business a larger safety net if they run into trouble. The second way a company can increase its equity is by expanding its assets and/or reducing its liabilities. Since equity is equal to a company’s assets minus its liabilities, increasing the former or decreasing the latter both cause a company’s equity to go up.
Investor Pro Tip: Return on Equity (ROE)
Return on Equity is a metric used to estimate how efficiently a company is able to generate profits with the assets and equity they have. It is calculated by dividing a company’s net income by their total equity. Net income is determined by taking a business’s revenue and subtracting expenses, interest, and taxes to arrive at the amount of profit a company managed to generate from doing business. Since equity is equal to the absolute value of a company’s assets, ROE is considered to be a measure of how effectively a company is using its assets to generate profit. For example, let’s say that two competing shops both earned a net income of $10 million this year, but Company A has $50 million in equity, and Company B has $20 million. Company A’s ROE is 20%, whereas Company B’s is 50%. Put another way, Company B managed to earn the same income as Company A with less equity to start with. This indicates that Company B is using its assets more efficiently than Company A, and is likely the better investment.
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About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.