The word equity can mean a few different things, depending on the context in which it is used and the people/group toward whom it is being directed. For example, equity can mean the percentage of a home's value that a homeowner has after paying on their mortgage for a certain period. That is one form of that is commonly understood. In the accounting world, equity generally refers to an owner's stake in a company once all relevant liabilities are subtracted. In this article, we look closer at the concept of owner's and shareholder's equity as they apply to the account.
Understanding equity in accounting
For our purposes, we will look at the two primary types as understood within the context of accounting. First off, there is, as has been noted, the idea of owner's equity in a business. This refers to what value an owner's share of the company is once all liabilities have been deducted. On the balance sheet, liabilities plus owner's equity have to equal total assets—in other words, the two sides of the balance sheet need to balance out when all is said and done.
It could also refer to the overall market value of a company. This would be determined based upon the shared values of that company. In looking at the current price of a corporation's shares, you can thus gain an understanding of its market value.
This is sometimes referred to as shareholders' equity. It might also be called the net worth of the company. If we look at it in terms of equity, upon paying off all debts and liquidating assets, the amount left over would be distributed to the shareholder--which of course is considered then the shareholders' equity.
The Different Values
There are a couple of key calculations used to arrive at the value of just as there are a couple of different meanings of the term itself. To find the book value of equity, for instance, you would subtract liabilities from assets and figure out the equity that way. This is the equation used to prepare the balance sheet in accounting.
Breaking it down further, it is important to understand what assets and liabilities would be included in this calculation. So for example, when tallying up the assets you would include both current and long-term assets, things such as cash, inventory, any prepaid expenses, real estate, equipment and machinery, accounts receivable, and also intangible property such as patents and trademarks.
As far as your liabilities go for this calculation, you again would consider both current and long-term liabilities to include any debt both short and long term, any deferred revenue, accounts payable, and any other financial obligations that the business might have at that given time. Accountants when factoring equity will also consider retained earnings as part of the equation.
Equity in accounting also looks at the market value of a company. The market and book values will often be different when it comes to calculating equity in accounting. One reason for this is that accountants when figuring out the market value will use projections versus historical information. When it comes to corporations, determining market value will often come down to multiplying the current share price for that publicly traded company by the number of outstanding shares.
If the company is not privately traded, however, the calculation could be a bit more involved. That is to say, you will need to get a formal valuation usually done by either a financial analyst or accounting firm for example. They will generally do comparable analyses as well as a discounted cash flow analysis. The latter would entail an analyst forecasting future cash flow and then discounting it back to the current value. As is evident, this method is fairly complicated versus the more straightforward calculation used if the company is publicly traded.
Personal equity
Sometimes when discussing equity in accounting, the meaning relates to a person's net worth. How exactly can a person figure out their net worth? Pretty simply actually. All they do (similar to how they'd figure out owner's equity/) is to subtract the value of all of their liabilities from that of their assets. So personal assets in such a case could be stocks, bonds, cash on hand, property, vehicles, retirement accounts, and the like. Liabilities in a personal equity situation include debts, lines of credit, mortgages, bills, and any other such financial obligations.
Recording equity in accounting
Businesses will record it on the balance sheet. As noted, the assets have to equal liabilities plus owner's equity and in this way, the balance sheet does balance out. The equity would be labeled out as either Owner's equity or Stockholders' equity. Of course, most businesses want the resulting number as far as equity goes to be a positive one. This means that the financial health of the business is in good shape overall.
If the resulting number is a negative one, then this signals that the business is in the red. This means that liabilities exceed the number of assets the business has. It, therefore, becomes extremely important to keep an eye on equity.
The concept of equity and where it consequently stands is also important for companies looking to raise money via equity financing. This essentially means that they are in a position to sell shares of the company to investors and thereby raise money that way. This prevents the company from having to take on additional debt, which if they are in the red could cause even more major problems down the road.
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