Outline:
- Equity refers to the portion of a business you personally own;
- Your equity is what’s left over from your assets after your liabilities are
paid.
The simplest way to understand equity is through example.
Hypothetically, let's say you are starting a co-working space. The first step is to buy a building. The price is $10 million and you have $2 million. You apply for a loan of $8 million and it’s accepted.
What’s your equity in the business?
The key thing to understand is you bought the building with both your own money and the loan.
Assuming you are a sole proprietor (it’s just you):
- Assets = $10 million
- Liabilities = $8 million
- So, equity = $2 million
Assets - liabilities = equity.
Over time, if you paid off more of the loan, your equity would increase as liabilities decrease.
E.g. If you pay off $1 million of the loan, to bring the balance down to $7 million
- Assets = $10 million
- Liabilities = $7 million
- So, equity = $3 million
The issue is, as the sole owner, you are liable for the whole loan if your co-working space fails.
Let’s compare this to a public corporation, where there are a few important differences.
What is a public corporation?
Public corporations are separate legal entities with ownership and management separated.
In contrast to sole proprietors, owners of public corporations are not necessarily running the business day to day. While it may seem bananas to invest in a business you may not be running, there are a few benefits.
The main benefit is that shareholders are only liable up to the investment they made in the business. For shareholders, if a business defaults on its loans, the maximum they can lose is their initial investment.
If we compare this to the co-working space example, you’d be on the line for the full $8 million because you were a sole proprietor, rather than a corporation.
In other words, shareholders have limited liability.
Examining equity
In accounting, assets equal liabilities plus equity.
And this kind of makes sense; the value of an asset doesn’t change if you own all of it or part of it (forgetting depreciation). The thing that changes is how much you owe to someone else, your liability to pay off the loan.
Going back to the co-working example. Once you start renting desks and start receiving money, that money will become part of your assets.
But your liabilities, are only the bank loan. Once you begin repaying the loan, your liabilities will decrease in value. Eventually, there will be a positive gap between your assets and your liabilities.
In other words, you will own more than you owe. Where does the excess go?
To shareholders! Whether you’re a corporate or a sole trader, it’s the same idea.
Your equity is what’s left over from your assets after your liabilities are
paid.
As an example. You have $10 worth of bananas (assets), you owe a friend $8 (liabilities). You really need to pay your friend back (it’s a current liability). So you sell your bananas.
After paying back your friend (your liabilities), you have $2. That’s your equity.
Equity and the sharemarket
For most people, equity is better known as something traded on a sharemarket, like the ASX. If you buy a share of Apple, you are buying equity.
Think about it like this, when you own a share of a company, you are entitled to a share of its assets (after it paid its liabilities), if it ever chose to wind down.
Most shareholders invest for less time than the life of the company. They invest in companies and when they need money, they sell their shares.
Either to the company or more likely to other investors.
So the book value of equity (assets — liabilities) may not be the best place for a current shareholder to see how much their equity is worth.
The problem with book value
The balance sheet represents the historical cost of assets, how the market values those assets. You can think of the market value of assets as the price the market would pay for the company’s assets in the event that the company were to be sold or shut down.
Further, book value fails to capture any future opportunities the business may have. Many investors look at and value companies by their future opportunities for growth, rather than what the company has done in the past.
So, investors often sell their equity back into the share market. Rather than selling it back to the company.
If you’re interested, you can determine the market value for a company’s equity by finding out their share price on Google. Then multiplying that number by the number of shares the company has issued.
Next step is to look at the money a company earned or its revenues.
Summary
Equity is the difference between the value of a business’ assets and the value of its liabilities. If a business owns an asset worth $10 million but owes $8 million to the bank, it’s equity is worth $2 million.
The key thing to remember is equity represents ownership.
