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In finance, equity is ownership of assets that may have debts or other liabilities attached to them. Equity is measured for accounting purposes by subtracting liabilities from the value of the assets. For example, if someone owns a car worth $24,000 and owes $10,000 on the loan used to buy the car, the difference of $14,000 is equity. Equity can apply to a single asset, such as a car or house, or to an entire business. A business that needs to start up or expand its operations can sell its equity in order to raise cash that does not have to be repaid on a set schedule.
When liabilities attached to an asset exceed its value, the difference is called a deficit and the asset is informally said to be "underwater" or "upside-down". In government finance or other non-profit settings, equity is known as "net position" or "net assets".
The term "equity" describes this type of ownership in English because it was regulated through the system of equity law that developed in England during the Late Middle Ages to meet the growing demands of commercial activity. While the older common law courts dealt with questions of property title, equity courts dealt with contractual interests in property. The same asset could have an owner in equity, who held the contractual interest, and a separate owner at law, who held the title indefinitely or until the contract was fulfilled. Contract disputes were examined with consideration of whether the terms and administration of the contract were fair—that is, equitable.
Any asset that is purchased through a secured loan is said to have equity. While the loan remains unpaid, the buyer does not fully own the asset. The lender has the right to repossess it if the buyer defaults, but only to recover the unpaid loan balance. The equity balance—the asset's market value reduced by the loan balance—measures the buyer's partial ownership. This may be different from the total amount that the buyer has paid on the loan, which includes interest expense and does not consider any change in the asset's value. When an asset has a deficit instead of equity, the terms of the loan determine whether the lender can recover it from the borrower. Houses are normally financed with non-recourse loans, in which the lender assumes a risk that the owner will default with a deficit, while other assets are financed with full-recourse loans that make the borrower responsible for any deficit.
The equity of an asset can be used to secure additional liabilities. Common examples include home equity loans and home equity lines of credit. These increase the total liabilities attached to the asset and decrease the owner's equity.
A business entity has a more complicated debt structure than a single asset. While some liabilities may be secured by specific assets of the business, others may be guaranteed by the assets of the entire business. If the business becomes bankrupt, it can be required to raise money by selling assets. Yet the equity of the business, like the equity of an asset, approximately measures the amount of the assets that belongs to the owners of the business.
Financial accounting defines the equity of a business as the net balance of its assets reduced by its liabilities. For a business as a whole, this value is sometimes referred to as total equity,to distinguish it from the equity of a single asset. The fundamental accounting equation requires that the total of liabilities and equity is equal to the total of all assets at the close of each accounting period. To satisfy this requirement, all events that affect total assets and total liabilities unequally must eventually be reported as changes in equity. Businesses summarize their equity in a financial statement known as the balance sheet (or statement of net position) which shows the total assets, the specific equity balances, and the total liabilities and equity (or deficit).
Various types of equity can appear on a balance sheet, depending on the form and purpose of the business entity. Preferred stock, share capital (or capital stock) and capital surplus (or additional paid-in capital) reflect original contributions to the business from its investors or organizers. Treasury stock appears as a contra-equity balance (an offset to equity) that reflects the amount that the business has paid to repurchase stock from shareholders. Retained earnings (or accumulated deficit) is the running total of the business's net income and losses, excluding any dividends. In the United Kingdom and other countries that use its accounting methods, equity includes various reserve accounts that are used for particular reconciliations of the balance sheet.
Another financial statement, the statement of changes in equity, details the changes in these equity accounts from one accounting period to the next. Several events can produce changes in a firm's equity.
Equity investing is the business of purchasing stock in companies, either directly or from another investor, on the expectation that the stock will earn dividends or can be resold with a capital gain. Equity holders typically receive voting rights, meaning that they can vote on candidates for the board of directors and, if their holding is large enough, influence management decisions.
Investors in a newly established firm must contribute an initial amount of capital to it so that it can begin to transact business. This contributed amount represents the investors' equity interest in the firm. In return, they receive shares of the company's stock. Under the model of a private limited company, the firm may keep contributed capital as long as it remains in business. If it liquidates, whether through a decision of the owners or through a bankruptcy process, the owners have a residual claim on the firm's eventual equity. If the equity is negative (a deficit) then the unpaid creditors take a loss and the owners' claim is void. Under limited liability, owners are not required to pay the firm's debts themselves so long as the firm's books are in order and it has not involved the owners in fraud.
When the owners of a firm are shareholders, their interest is called shareholders' equity. It is the difference between a company's assets and liabilities, and can be negative.If all shareholders are in one class, they share equally in ownership equity from all perspectives. It is not uncommon for companies to issue more than one class of stock, with each class having its own liquidation priority or voting rights. This complicates analysis for both stock valuation and accounting.
A company's shareholder equity balance does not determine the price at which investors can sell its stock. Other relevant factors include the prospects and risks of its business, its access to necessary credit, and the difficulty of locating a buyer. According to the theory of intrinsic value, it is profitable to buy stock in a company when it is priced below the present value of the portion of its equity and future earnings that are payable to stockholders. Advocates of this method have included Benjamin Graham, Philip Fisher and Warren Buffett. An equity investment will never have a negative market value (i.e. become a liability) even if the firm has a shareholder deficit, because the deficit is not the owners' responsibility.
An alternate approach, exemplified by the "Merton model",values stock-equity as a call option on the value of the whole company (including the liabilities), struck at the nominal value of the liabilities. The analogy with options arises in that limited liability protects equity investors: (i) where the value of the firm is less than the value of the outstanding debt, shareholders may, and therefore would, choose not to repay the firm's debt; (ii) where firm value is greater than debt value, the shareholders would choose to repay—i.e. exercise their option—and not to liquidate.
In financial accounting, a balance sheet is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a business partnership, a corporation, private limited company or other organization such as government or not-for-profit entity. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A balance sheet is often described as a "snapshot of a company's financial condition". Of the four basic financial statements, the balance sheet is the only statement which applies to a single point in time of a business's calendar year.
In corporate finance, as part of fundamental analysis, economic value added is an estimate of a firm's economic profit, or the value created in excess of the required return of the company's shareholders. EVA is the net profit less the capital charge ($) for raising the firm's capital. The idea is that value is created when the return on the firm's economic capital employed exceeds the cost of that capital. This amount can be determined by making adjustments to GAAP accounting. There are potentially over 160 adjustments but in practice, only several key ones are made, depending on the company and its industry.
In accounting, book value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset. Traditionally, a company's book value is itsminus intangible assets and liabilities. However, in practice, depending on the source of the calculation, book value may variably include goodwill, intangible assets, or both. The value inherent in its workforce, part of the intellectual capital of a company, is always ignored. When intangible assets and goodwill are explicitly excluded, the metric is often specified to be tangible book value.
Debits and credits in double-entry bookkeeping are entries made in account ledgers to record changes in value resulting from business transactions. A debit entry in an account represents a transfer of value to that account, and a credit entry represents a transfer from the account. Each transaction transfers value from credited accounts to debited accounts. For example, a tenant who writes a rent cheque to a landlord would enter a credit for the bank account on which the cheque is drawn, and a debit in a rent expense account. Similarly, the landlord would enter a credit in the rent income account associated with the tenant and a debit for the bank account where the cheque is deposited.
In finance, valuation is the process of determining the present value (PV) of an asset. In a business context, it is often the hypothetical price that a third party would pay for a given asset. Valuations can be done on assets or on liabilities. Valuations are needed for many reasons such as investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability.
Net worth is the value of all the non-financial and financial assets owned by an individual or institution minus the value of all its outstanding liabilities. Since financial assets minus outstanding liabilities equal net financial assets, net worth can also be conveniently expressed as non-financial assets plus net financial assets. It can apply to companies, individuals, governments or economic sectors such as the sector of financial corporations or to entire countries.
Financial accounting is the field of accounting concerned with the summary, analysis and reporting of financial transactions related to a business. This involves the preparation of financial statements available for public use. Stockholders, suppliers, banks, employees, government agencies, business owners, and other stakeholders are examples of people interested in receiving such information for decision making purposes.
In financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit from price movement – stocks that are judged undervalued are bought, while stocks that are judged overvalued are sold, in the expectation that undervalued stocks will overall rise in value, while overvalued stocks will generally decrease in value.
In economics and accounting, the cost of capital is the cost of a company's funds, or from an investor's point of view is "the required rate of return on a portfolio company's existing securities". It is used to evaluate new projects of a company. It is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.
The retained earnings of a corporation is the accumulated net income of the corporation that is retained by the corporation at a particular point of time, such as at the end of the reporting period. At the end of that period, the net income at that point is transferred from the Profit and Loss Account to the retained earnings account. If the balance of the retained earnings account is negative it may be called accumulated losses, retained losses or accumulated deficit, or similar terminology.
Enterprise value (EV), total enterprise value (TEV), or firm value (FV) is an economic measure reflecting the market value of a business. It is a sum of claims by all claimants: creditors and shareholders. Enterprise value is one of the fundamental metrics used in business valuation, financial analysis, accounting, portfolio analysis, and risk analysis.
A capital requirement is the amount of capital a bank or other financial institution has to have as required by its financial regulator. This is usually expressed as a capital adequacy ratio of equity as a percentage of risk-weighted assets. These requirements are put into place to ensure that these institutions do not take on excess leverage and risk becoming insolvent. Capital requirements govern the ratio of equity to debt, recorded on the liabilities and equity side of a firm's balance sheet. They should not be confused with reserve requirements, which govern the assets side of a bank's balance sheet—in particular, the proportion of its assets it must hold in cash or highly-liquid assets. Capital is a source of funds not a use of funds.
In finance, leverage is any technique involving borrowing funds to buy things, hoping that future profits will be many times more than the cost of borrowing. This technique is named after a lever in physics, which amplifies a small input force into a greater output force, because successful leverage amplifies the comparatively small amount of money needed for borrowing into large amounts of profit. However, the technique also involves the high risk of not being able to pay back a large loan. Normally, a lender will set a limit on how much risk it is prepared to take and will set a limit on how much leverage it will permit, and would require the acquired asset to be provided as collateral security for the loan.
The debt-to-equity ratio (D/E) is a financial ratio indicating the relative proportion of shareholders' equity and debt used to finance a company's assets. Closely related to leveraging, the ratio is also known as risk, gearing or leverage. The two components are often taken from the firm's balance sheet or statement of financial position, but the ratio may also be calculated using market values for both, if the company's debt and equity are publicly traded, or using a combination of book value for debt and market value for equity financially.
The return on equity (ROE) is a measure of the profitability of a business in relation to the equity. Because shareholder's equity can be calculated by taking all assets and subtracting all liabilities, ROE can also be thought of as a return on assets minus liabilities. ROE measures how many dollars of profit are generated for each dollar of shareholder's equity. ROE is a metric of how well the company utilizes its equity to generate profits.
Business valuation is a process and a set of procedures used to estimate the economic value of an owner's interest in a business. Here various valuation techniques are used by financial market participants to determine the price they are willing to pay or receive to effect a sale of the business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal purposes such as in shareholders deadlock, divorce litigation and estate contest.
A statement of changes in equity and similarly the statement of changes in owner's equity for a sole trader, statement of changes in partners' equity for a partnership, statement of changes in shareholders' equity for a company or statement of changes in taxpayers' equity for government financial statements is one of the four basic financial statements.
The fundamental accounting equation, also called the balance sheet equation, represents the relationship between the assets, liabilities, and owner's equity of a person or business. It is the foundation for the double-entry bookkeeping system. For each transaction, the total debits equal the total credits. It can be expressed as furthermore:
A financial ratio or accounting ratio is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios.
Corporate finance is the area of finance that deals with the sources of funding, and the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value.