Our Context
To make our practical finance section as useful and practical as possible, all the definitions and insight will be in the context of a E-Bikes shop that we call E-Zee Bikes. This gives you a more hand ons view and more relatable to what the numbers actually mean.
IN A NUTSHELL
Ownership value in a business.
GLOSSARY DEFINITION
WORKED EXAMPLE
Equity is calculated using the basic accounting equation:
Equity = Total Assets – Total Liabilities
Here, assets are resources owned by the business (like e-bikes, cash, equipment), and liabilities are what the business owes to others (like loans, accounts payable).
For our E-bike shop, if it has assets worth £500,000 (e-bikes, cash in bank, equipment) and owes £300,000 (bank loans, supplier credit), its equity is £200,000.
USED IN A PHRASE
“The increase in equity demonstrates our e-bike shop is flying!”
DETAILED MEANING
Components of Equity
Paid-in Capital: This includes the money that shareholders have invested in the business. For a small business, this could be the initial investment made by the owners or investors to start the business.
Retained Earnings: These are the cumulative net earnings or profits of a company that have not been distributed to shareholders as dividends and are reinvested in the business. For our e-bike shop, it represents profits from selling e-bikes and related services, minus any dividends paid out.
Other Components: These might include treasury stock (company’s own shares bought back), unrealized gains or losses, and reserves.
Importance of Equity
Source of Funding: Especially for startups, equity can be a primary source of funding. Owners might inject capital, or investors might provide funding in exchange for a stake in the business.
Indicator of Financial Health: A positive and growing equity indicates that the business is financially healthy and potentially profitable. Negative equity, on the other hand, is a red flag, indicating potential financial distress.
Leverage and Risk Management: Equity is crucial in managing the risk and leverage of a business. A higher equity relative to debt (low leverage) indicates a safer financial position, as the business is not overly reliant on external debts.
Return on Equity (ROE): This is a key metric for measuring the profitability and efficiency of a business in generating returns on shareholders’ investments. It is calculated as Net Income / Average Shareholders’ Equity.
Methods to increase equity
Reinvesting Profits: Instead of paying out all profits as dividends, reinvesting them increases retained earnings, thereby boosting equity.
Issuing More Shares: For businesses structured to allow it, issuing more shares can raise additional capital, thus increasing equity.
Reducing Liabilities: Paying off debts reduces liabilities, thereby increasing equity.
Improving Operational Efficiency: Increasing profitability through better sales, cost management, or new revenue streams can lead to higher retained earnings.
Implications of changes in equity
Valuation and Investment Attractiveness: Changes in equity can affect the valuation of a business and its attractiveness to investors. Increasing equity often makes a business more attractive to potential investors.
Debt Capacity: A strong equity base can enable a business to borrow more if needed, as it indicates a higher ability to repay.
Shareholders’ Confidence: Positive changes in equity can boost the confidence of shareholders and potential investors in the management and future prospects of the business.