What is Shareholders’ Equity?
If you’ve been reading up on investments and financial matters, there’s a good chance that you’ve come across the term equity. Although it’s a fairly common word, there are several different meanings — all similar to one another, but with enough distinction that it’s worth a deep dive into each definition. Today, we will be talking primarily about shareholders’ equity and owners’ equity.
The two terms are sometimes used interchangeably, although they’re not quite the same; they refer to public companies and private ones, respectively. We’ll cover what distinguishes each type a little later.
Types of Equity
For starters, you can think of equity as the value of ownership in … something. That “something” is responsible for the different kinds of equity. However, know that equity always refers to the value of an entity. For our purposes, that value is the ownership of a business. Let’s take a quick look at some other definitions before moving on to shareholder’s equity.
- Home equity is the difference between the home’s fair-market value and all outstanding liens on the property. In other words, it’s the amount of money that you’ve paid on your mortgage. When a homeowner takes out a home equity loan or a home equity line of credit, they’re borrowing money against that value — essentially, using it as collateral with the bank or other lender.
- One type of equity is stock shares, which represent ownership in a company. Some compensation packages for employees include stock compensation or share-based compensation. This basically means that the company gives employees a chunk of the company in the form of stocks. Equity as compensation often happens in startups when the company’s leaders don’t yet have cash flow that’s substantive or reliable enough to pay out generous salaries, but they are equipped to provide shares of the company. This can be a win-win situation; an employee with equity is usually more invested in their career and will thus work harder to help the company succeed. On the other hand, receiving equity in lieu of a higher paycheck can be a disincentive to employees who are more concerned with their current financial state and therefore aren’t as focused on their future.
- Equity is also a fundamental component of a corporation’s balance sheet. That’s a financial statement that, along with the income statement and the cash flow statement, makes up the core financial documents to create a snapshot of the business’s health in terms of its economic security. Additionally, understanding equity as it is reflected on the balance sheet provides information about its capital structure.
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Now we come to shareholders’ equity. You may see this type of equity referred to by several different names, including net assets, residual equity, or stockholder’s’ equity. As we mentioned above, it can sometimes be called owners’ equity, as well. However, there is a small difference in those two terms — shareholders’ equity is most often used when discussing public companies, while private companies generally use the term owners’ equity.
As we’ve already learned, equity is the worth or value of a company minus its debts. Any shareholder with equity can be considered as a pro-rata owner. Pro rata is a legal term that signifies an investor’s rights to keep their ownership percentage. Investors are not, however, obliged to maintain their share.
Assets and Liabilities That Factor Into Shareholders’ Equity
Shareholders’ equity equals the company’s total assets minus its total liabilities, so it’s important to understand what those are. Both assets and liabilities can be broken down into two main categories: current and long term.
Current assets are those that could easily and relatively quickly be turned into cash. This includes accounts receivable, inventory, and assets known as cash equivalents such as bank accounts or short-term government bonds.
What does “relatively quickly” mean in this context? Essentially, that descriptor refers to any assets that the company would not be able to turn around within 12 months. That means future, or long-term, assets are the opposite: anything that could be converted, but not in the time frame of a year. These include items such as heavy equipment, facilities, and even patents.
Current liabilities, then, are accounts payable, taxes payable, and any other payment or debts that will come due within the next year.
As you’ve probably already sussed out by deduction, long-term liabilities are any debts that the company won’t have to repay in the upcoming 12 months. Some examples of long-term liabilities are long-term leases, most bonds payable, and any pension obligations.
Understanding the Importance of Shareholders’ Equity
Now, it’s time to outline the reasons that shareholders’ equity is such a vital concept to understand and evaluate.
- First, shareholders’ equity can be used as a measuring tool, when examined side by side with the company’s profits, to help calculate return on equity, or ROE. This, in turn, can provide a great deal of insight into how effectively management is deploying its capital. The more capital a company maintains, the lower its ROE will be — and the lower it will rank as a solid investment opportunity. Investors should look for companies with a high ROE for the exact same reasons that homeowners who are remodeling prior to selling their home choose renovation projects with a high return on investments, or ROI.
- It stands to reason that equity can also reflect an investor’s stake or the amount of ownership they have in the company. In fact, shareholders’ equity is often referred to as stakeholders’ equity. Depending on the company itself and the amount of equity the investor has, they may enjoy certain privileges and perks, such as the ability to vote on decisions that can potentially change the company’s future — and future earnings.
- Shareholders’ equity also means that investors are entitled to a portion of the company’s capital gains. If you’re not familiar with this term, capital gains can be thought of as profit, as they represent the increase in value of an asset after it has been sold. Again, this is subject to the type of industry and how the shareholder’s equity is represented. Some firms choose to share the dividends with their shareholders. Rather than paying dividends, other companies might opt to retain and reinvest any capital gains.
- Equity is also a measure of the company’s economic well-being, as we discussed earlier. Naturally, having a great deal of equity means that the company is doing well and, in most cases, is fairly immune to insolvency and/or bankruptcy. Shareholder equity figures that are low, or even negative, can mean that tough financial times are ahead, but they are not necessarily a death knell. If the business can grow its profits quickly enough, then it may very well be able to outrun its liabilities, compensate for any debts that are coming due, and subsequently boost its equity levels.
Shareholders’ equity is only one aspect of a company’s balance sheet — an important one, to be sure, but one that can’t be isolated from the other aspects of the business’s financial standing. As in just about every other aspect of investing and economics, there are myriad factors at play, and it’s crucial not to isolate any of those factors when deciding to invest, or even when you’re simply looking at how well the company is faring. Rather, measuring each of these factors against the others and taking a big-picture view is essential to a holistic understanding of the business in question and its future.