While the concept of equity and/or equities can apply to a few different things within the context of business, most understand equities to mean shares of stock that are owned by a company’s shareholders. Additionally, equity can refer to the balance sheet value of a firm. With either meaning, equity is indeed a very important term as far as investors are concerned. In this article, we look at the definition of the word equities/equity and the importance of this concept as far as the world of investing.
Understanding Equity: Some Basics
The term equity and/or equities signifies a few different things to an investor. It could indicate the number and amount of shares of stock that someone holds in a company. Equity could also be referring to the total value of all shareholder equity in that company. And finally, equity is sometimes used to discuss an ownership structure connected to private equity. While these all have intersections and similarities, their meanings do have consequential differences as far as investors are concerned.
Equities = Shares of Stock
When using the word equities, most often people are talking about the shares of stock that an investor owns in a company. This can be either common or preferred stock. So if an investor is referring to their equity portfolio, this is directly related to their total stock holdings. Equities signify that a person owns a certain percentage of a company by their stock shares. If for example, someone purchases 500 shares of a specific company’s stock, they now have equity in that company; that is to say, they own a percentage of that particular organization because of the equities they hold.
Equity on a Balance Sheet
The concept of shareholder’s equity as far as the balance sheet goes is a bit different. This is referring not to individual equities held by an investor but rather to the larger idea of ownership of a firm. Shareholder’s equity shows how much of the company is owned by investors. And if the business were to have to shut its doors and consequently payout to the shareholders (after deducting all of the liabilities and debts owed), the shareholder equity serves to show what the company is worth.
Shareholder’s equity can be a very good indicator of where a company’s financial health stands when all is said and done. If for instance there is negative shareholder equity, this could mean that the company is in financial trouble and consequently does not have the means to meet all of its debts and obligations. For potential investors, this is a definite red flag and will thus make it all the more difficult for a company to raise capital.
Where Shareholder’s Equity Comes From
When looking specifically at the broader concept of stockholder’s equity, versus individual equities owned by investors, there are three primary sources as far as where this stockholder’s equity comes from. The capital stock relates to the money raised from investors where the company sold shares of its stock in return for cash. There are also retained earnings. These are the profits that a company has held onto for reinvestment purposes rather than paying out as dividends to investors And finally, there is a paid-in surplus, which refers to capital given by investors in exchange for stock.
On the balance sheet, you will usually find the company’s assets in one column and then in the other, they will list their liabilities in tandem with the owner’s equity. The assets generally come first followed by liabilities and then shareholder’s equity. The total amount of the firm’s assets should equal all liabilities plus the owner’s equity. For a given reporting period, the balance sheet, in this respect, provides a highly useful picture for understanding exactly where a company stands financially.
For the owner’s equity to increase, the company needs to be able to generate more earnings. This in turn, also enables the company to better manage its current debt. The more stockholder equity, the better off the company is from a financial vantage point. And if the company should suffer an unexpected hit or have to cover more losses than expected, they are in a better position to do so given the positive overall owner’s equity position.
Even though shareholders do have equity in a company, if the company is experiencing a downturn as far as the finances are concerned, shareholders cannot simply demand to be paid. This is why before buying equities (or securities) an investor does need to study the financial statements to include the balance sheet and income statement among other documents. Such documents paint a clearer picture of where the company is currently and they can help investors make future projections as well.
If stockholder equity is relatively low, or worse, if there is negative equity, then this indicates that there could be a problem. Perhaps the firm is carrying too much debt and consequently has too many liabilities thereby prohibiting the business from being profitable. There are some instances though, especially as seen in newer companies, where lower stockholder equity isn’t quite as much of a concern. Additionally, if a company has minimal expenses, a lower owner’s equity isn’t necessarily a red flag. This is because the business doesn’t require as much operating cash to produce results and thus spur cash flow. Wealth is created more easily even if stockholder equity is lower.
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