Understanding Equity

Equity is defined as the residual interest in the assets of an entity that remains after deducting its total liabilities. It can also be defined as ‘Net Assets’. (Total assets of a corporation minus its total liabilities). It is also referred to as ‘Net Worth’. Equity is recorded on the ‘Balance-Sheet’ statement of a company.

It is quite possible that the net worth of a company could be in a negative position. It such circumstances the company is deemed to be insolvent. Some credit and financial institutions will refuse to even rate the credit worthiness of such a company.

The equity of a corporation has two component i) Capital Stock and ii) Retained earnings.

Capital stock is preferred and common stock that the owners purchase through an initial offering or a later sale by the corporation. Retained earnings is the portion of the corporation’s profits that are retained or reinvested in the firm. A financial statement should reflect a) the portion of the owner’s equity that is financed by the owners and b) the portion that comes from the retention of profits or earnings.

Capital stock broken down:

1. Common Stock or Equity: This account represents the capital that is contributed by the owners to purchase the stock. This account is usually is equal to the number of outstanding shares of stock times the par or stated value of the stock. For example if a corporation has 1,000 outstanding shares at $25 par stock. The common stock account will show $25,000 as a balance.

2. Preferred Stock: This account reflects the amount of any outstanding preferred stock. This account is usually is equal to the number of outstanding preferred shares of stock times the par or stated value of the stock.

3. Retained Earnings: At the end of each year if a company makes profits it may choose to either retain a portion or the full amount in the business. If the company does not pay dividends to its shareowners it may retain the full amount. If it chooses to declare a portion of its profits as dividends the rest then is retained in the business as retained earnings.

The equity for sole proprietorship, partnership or joint venture is referred to as owner’s ‘capital’ on the balance sheet, instead of owner’s ‘equity’, as in the case of a limited corporation. Owners capital at the end of an accounting period is generally the funds contributed by the owners plus net income earned to date minus the funds distributed to owners

Equity is a measure of the long-term liquidity of a company. It is against this equity that a company leverages both its short-term and long-term borrowing/debt. Depending upon the line of business, different industries have different debt to equity ratio. For example the average retail trade operates at approximately $2.50 of debt for every $1.00 that it has as equity. As credit analysts we should observe if a company is within its industry standards and is leveraged well. Most secured creditors (example a bank) will request its debtor to maintain this ratio at a certain level to operate with its loans. Again while analyzing our customers/prospect, we as unsecured creditors should find out if the bank/financial institution is seeking any such condition. If so then this is the first ratio that we should calculate to see how far or close is the customer/prospect from a default condition on its secured debt.

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