Equity in Finance refers to investors ownership in a company and represents the amount that they would receive after the liquidation of assets and paying off the liabilities such as debt. It is calculated as the difference between the assets and liabilities shown on the balance sheet of a company.
When an investor invests in the share of any company, such an investor becomes an owner of the company’s net assets in proportion to the shares held by such an investor. The formula to calculate equity is given below –
Equity = Assets – Liabilities
Equity shareholders earn profit from capital gains and capital appreciation due to an increase in stock prices. They also get the right to vote in the important decisions of the company. However, there is a certain risk in investing in shares.
- An equity shareholder of a company gets repaid only at the time of liquidation and that too to the extent of available surplus after meeting all liabilities and preference shareholders.
- Shareholders get the right to vote as well as to join the member meetings of the company.
- Shareholders get the right to receive dividends. However, it depends on the company’s policy as to whether the dividend has to be paid for any year or not.
- Shareholders have limited liability, and they are not liable to pay any further amount even at the time of liquidation.
How does it Work?
When an individual or any other investor invests in the share of a company, they become equity shareholder, and they gain ownership in the company’s net assets to the extent of shares held by them. The shares don’t have any repayment date, and it is only upon liquidation that the equity shareholders get repaid to the extent of residual resources available. The shareholders can transfer their shares, and the person to whom these shares are transferred becomes the new equity holder for such proportionate holding.
In the balance sheet of a company, it can change due to several factors such as the change in the realized and unrealized profits, issue of fresh share capital, buyback of existing share capital, dividend declaration, and so on.
Example of Equity
Suppose a company ABC Ltd. is engaged in the manufacturing of textiles. Annual Report for the year ending on 31 March’19 was published. Following are the details of the Balance Sheet. Let us calculate the equity of ABC Ltd. as on 31 March’19 with the information provided below-
Calculation of equity is as follows –
- = $51,500,000 – $11,000,000
- = $40,500,000
Market Value of Equity
In the case of publicly traded common stock, the market value of equity or market capitalization is calculated as multiple of the number of shares outstanding and the company’s current stock price. Its market value can be construed as the company’s value as seen by the market, i.e. investors.
Example: As on date, a company has 250 million shares outstanding, which are trading for $65 per share. In this case, the market value of equity can be calculated as follows:
Market Capitalization = No. of Equity Shares Outstanding * Current Market Price per Share
Market Capitalization = 250 million * $65 = $16,250 million
Why is Equity Important?
Equity is not only beneficial for the investor but also the issuing company. For the investor, it helps in earning a high rate of return on their investment through capital gain and getting the proportionate ownership of that company. For the issuing company, equity helps get the required amount of capital to start or continue their business as the required capital is divided into small portions that are then purchased by the investor.
- High-Rate of Return: It allows the investor to earn a high rate of return on their investment as they become the owner of the company. They will get a return if there is any capital gain or stock appreciation.
- Helpful at the Time of Inflation: The rate of return an investor gets in the equity is usually higher than compared to the rate of inflation so it increases the purchasing power of the investor.
- Easy Process: The process of investing in it is comparatively easy than investing in other investment types as the investor needs to find the right broker and the rest of the work will be taken care of by the broker.
- Higher Risk: The risk in equity is higher than investing in other investments.
- Dependency on the Company’s Performance: The investor has no control over the working or performance of the company, and if the company bears a loss, the same would be borne by the shareholder also.
Equity is very important for the investor as it shows the value attributable to them in the company. Equity ownership makes them the owner of the company’s net assets. It also enables the shareholder to enjoy the right to vote and attend the meetings related to the company’s affairs. This increases the interest of shareholders towards the company.
This has been a guide to Equity and its meaning. Here we discuss how it works, characteristics, examples and its importance. You can learn more from the following articles –