Equity

Accounting ·

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Assets, liabilities, and equity are three core accounting concepts. It's impossible to evaluate a company properly without a thorough knowledge of them.

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The word “equity” has many meanings but, in this article, we focus on equity in the general accounting sense, although we briefly cover other kinds of equity too. We explain what is equity, how to calculate it and we also provide some real-life examples based on a recent annual report of a public company.

Table of Contents

What is Equity in Financial Accounting?

Equity is anything that an individual or a company owns, excluding the amount that's necessary to pay off all of the liabilities such as debt, financial obligations, etc. Another common definition of equity states that it's the amount of money that would be returned to the company's shareholders in case of its liquidation, i.e. if all of its assets were sold and all of the debts were paid off. Equity of any company can be found in its balance sheet, right under its assets and liabilities.

Formula

To figure out the company's equity, given its assets and liabilities, use the following formula:

$$ E = A - L $$

Where:

  • E: Owner's Equity
  • A: Assets
  • L: Liabilities

Here is a simple example just to illustrate how this formula works. If a company has $35,000,000 of assets and $25,000,000 of liabilities, the difference between them, ($35,000,000 - $25,000,000 = $10,000,000), would be the company's equity.

Understanding Equity

Generally speaking, equity is something like “pure assets” (sometimes called “net assets), a chunk of a company that has a real value. It doesn't help much to have a lot of assets unless their value is greater than the value of the company's liabilities. That is why it's important to measure and understand equity. Looking at the company's equity is a reliable way to assess its overall financial health, although it doesn't always show the full picture. In addition to assets, liabilities, and equity, it's important to read the rest of a company's income statement before making any bold conclusions.

Equity answers a simple question:

“What's this company really worth?”

Let's assume that a company with $1,000,000 of assets and $500,000 of liabilities has $100,000 of net income per year. Its equity currently equals $500,000, but every year it adds $100k to its assets and, after 5 years, its equity supposed to be $1,000,000. No guarantees, of course. No one knows the future, but it can justify buying a company for more than the worth of its equity.

So, it's unfair to value a good company based only on its equity. That's why it's important to make a distinction between book value (equity) and market value (how much it really costs to buy a share of a company).

Coca-Cola is an old and successful company and it has $20B worth of equity. It also has 4.28B shares outstanding, which translates to ~$4.76 of equity per share. Unfortunately, it's impossible to buy a share of that great company even for $5, you have to pay $55 for such a privilege. That's a big difference, isn't it? Coca-Cola might be a great company, but not necessarily “10 x equity” great.

Equity shows the total net value (book value) of a company as it takes into account its debts and other liabilities, which can be quite different from the current market value of the same company. Equity and book value is the same thing. Market value is a different thing and it's impossible to figure it out based on the equity value alone.

What Affects Equity in Accounting?

It's a common question in accounting:

“Will this transaction affect the company's equity?”

Let's briefly cover this question.

For instance, if a company bought $250,000 worth of equipment with cash, would this action affect its equity? The answer is “no” because equipment and cash are recorded in the assets part of the balance sheet, thus you will see the -$250,000 of cash and +$250,000 of equipment, resulting in zero change in total company's equity. Well, what if the company bought this equipment “on account” (by using a credit), would that affect the total equity? The $250,000 worth of equipment will be still added to the assets, and $250,000 of debt will be recorded as liabilities, resulting in no change in total equity. If the company stole this equipment and didn't pay anything for it, which is a rather humorous and hypothetical case, then the equity should be changed, but if someone does such a thing, it's probably better to keep it off the record.

What if that company pays off $100,000 of its debts with cash, would it change the equity? No, because we have got two entries: -$100,000 of cash (left assets side of the accounting equation), and -$100,000 of the debt (right liabilities size).

Primarily, there are only two ways to change company's equity:

  • Increase earnings
  • Add more money (capital) from outside

A company's net income for every fiscal year adds to its equity as “retained earnings”, minus any distributions of profits it made to its shareholders. In addition to that, a company may raise stockholder's equity by issuing new shares. Also, equity can be increased if one of the owners just invests an additional sum of money into the company.

Negative Equity

Most of the companies have more assets than liabilities which means their equity is positive, that's what investors expect from a good enterprise.

Some companies, however, may end up with more liabilities than assets, dragging their equity into the negative territory. This usually means that a company borrowed too much and it can't manage its debts properly, or that the company has some problems with generating revenue to cover those debts. Negative equity doesn't always mean insolvency or bankruptcy, a company can function with a reasonably low negative equity for a while, but it's definitely a red flag. As long as a company can show a positive cash flow (and a potential to increase it), its investors might allow it to restructure its debts and continue its operations.

It's hard to find an example of a well functioning corporation with negative equity, although there are many small firms and start-ups out there that are well below zero. In 2018, Chris MacDonald at fool.ca wrote that investors should be careful with two Canadian companies Bombardier and Dollarama, ticker symbols TSX:BBD.B and TSX:DOL, as they showed negative equity in their 2018 reports. Those two companies work in very different businesses; one in the heavy manufacturing industry, where negative equity looks more dangerous, and another one in retail, where it looks less concerning. However, both companies have been consistently showing a net revenue since then and their equity keeps growing. Looks like those companies have managed to come out of this uncomfortable spot, yet Chris’ concerns were justified because negative equity smells like a risky investment.

Real-life Example

To continue our tradition, let's look at Apple Inc.‘s annual report for 2019 which can be found here. Company's equity is located at the bottom of page 34 in the consolidated balance sheet.

➤ Read also: How to Read an Annual Report?

This section is quite short and it has a few entries. However, there are more details about Apple's equity on the next page.

Here is what Apple's equity consists of (in million U.S. dollars):

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The equity part of the balance sheet is short, yet it may seem even more confusing to some people than assets and liabilities. In some cases, it might be easier to check the websites like marketwatch.com where such data is structured and organized in a clear way. In any case, let's break the data down and dig a bit deeper in order to understand some of those entries.

As you can see, the equity section mentions common stock, retained earnings, and accumulated other comprehensive income or loss. The first entry, the common stock, and additional paid-in capital tell us how much money the company had received starting from issuing shares during its IPO and later. Retained earnings are easy to understand as the company's net income ($55B), minus paid dividends ($14B), and common stock repurchased ($67B), as well as few other operations. The result of those transactions is added to the beginning balance of $70B to get the ending balance of $45B.

It's worth to note that activities of a company related to its equity can be confusing and they are hard to cover in this short article. Corporate Finance Institute has a nice guide on how to read equity, but even this is not enough and each particular case and a company has to be studied separately.

For instance, to understand why a company would want to buy back its own shares as, Apple did, and especially in such a big amount of 67 billion dollars in just one year, you might need to dig deeper. Emily Stewart at Vox has a good article about it with many theories and ideas many of which seem reasonable. Long story short: it's just more profitable. What a surprise.

An old and simple understanding of equity in accounting, as just the accumulated capital and revenues, is outdated. Now, corporations play with their shares a lot for several reasons and occasionally the part of the report about equity gets even bigger than traditionally more important assets, liabilities and even income. However, equity in accounting is usually more simple when it comes to small and non-public companies.

Equity in Investing

Many terms in economics are a bit confusing because the same term might have a number of different meanings. It's true for assets and liabilities, as they are used not only in accounting but also in personal finance and investing. However, the meaning of these terms is pretty much the same in all fields. Equity also can be understood in a number of ways, which are mostly quite similar.

In this article, we explain equity as an accounting term, but in investing, this word has a slightly different meaning. Equity in investing is often understood as any non-fixed income investments that an investor or an investment company may have. Those are shares, mutual funds (that often consist of shares), futures and options, arbitrage schemes, etc. So, it's basically any liquid and volatile traded market security with no guaranteed income. A good example of non-equity investments is a bond with a known maturity and fixed income, which is often considered a conservative instrument.

When someone says that his financial portfolio is 90% in equities, it means that he has the most of his capital allocated in liquid, volatile and somewhat risky stocks and funds that consist of stocks that are expected to generate a higher rate of return than the rest of the portfolio.

Lastly, in marginal trading, equity is the net value of securities minus all the borrowings.

Equity vs Net Worth in Personal Finance

In personal finance, equity of an individual is usually called net worth and it's the same thing as equity of a company. Net worth equals to all personal assets (house, car, cash, etc.) minus all the liabilities (credit card debt, car loan, mortgage, etc.).

When we hear that a certain celebrity or a politician “worth” X amount of money, it doesn't quite imply equity in the traditional way because person's liabilities are usually not considered (public people aren't required to report their debts, unlike public companies) and the value of somebody's assets is often calculated as the current market value, not a book value.

Equity in Real Estate

Real property value is also sometimes called equity in real estate business. It's the difference between the current market fair value of the property and the amount of the mortgage that has to be paid. For example, let's say that an individual bought a house for $1,000,000 with the mortgage of $1,200,000. After 10 years the value of the house went up by 25%, and he also managed to pay off half of the mortgage. At the beginning of the deal, the equity was -$200,000, but after 10 years it had increased to $650,000.

Private equity (PE)

There is another meaning of the term “equity” in investing that should be mentioned.

Private equity (PE) is understood as an investment company (an investment fund, venture capital firm or an angel investor organized as limited partnerships) that specializes in investing in companies that aren't publicly traded. This term isn't quite related to what equity means in investing and accounting, it appeared in 1980s as a rebranding of an evil LBO (leveraged buyout) companies which were taking control over firms to sell them in parts and use them as leverage to buy even more to do it again. In today's world, private equity firms don't have such a bad reputation, although they continue to look as a bit shady.

Private equity is not the same as a hedge fund, you can read about the key differences between them here.

The main idea behind private equity firms is that they operate with equity (the difference between assets and liabilities), therefore they're not just investment firms, they're something bigger with a complex strategy which involves a long-term commitment and some direct management.


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