Almost everyone understands home equity — this private equity is the percentage of your home you own after paying down your mortgage. More technically, it’s the value of an asset, like property, minus its liabilities, like debt.
But the term “equity” also applies to things like businesses. As a business owner and entrepreneur, you need to know how equity affects your enterprises and how to calculate it for your shareholders, mainly before you go public. This article will discuss how to calculate equity for shareholders in detail.
How equity works
Equity is the value of an asset without its liabilities.
For example, say that you own a business building, like a retail storefront, worth $500,000. You’ve paid down $300,000 of that property’s mortgage, leaving you with $200,000 plus interest in liabilities. Thus, the equity in the property is (roughly) the $300,000 you own of the building.
This is a basic example, of course. You can look for and calculate the equity in everything from basic items to business enterprises and stock portfolios. Regardless, equity is vital so that investors, shareholders and other interested parties can determine the actual value of an asset.
Related: How to Safely Tap Home Equity in a Financial Emergency
Shareholders’ equity explained
Shareholders’ equity, therefore, is the net worth or total dollar value of the company that would be returned to shareholders of the company’s stock if:
- The company’s assets were to be liquidated.
- The company’s debts were to be paid off.
Put more simply, shareholders’ equity is the total equity left over that shareholders would have to divvy up between themselves if a company was liquidated entirely to settle any outstanding debts.
You can also think of stockholders’ equity (or SE) as the owners’ collective residual claim on company assets only after outstanding debts are satisfied. Shareholders’ equity is the same as a firm’s total assets minus its total liabilities.
It’s essential to know how to calculate share owners’ equity for a variety of reasons:
- Investors and analysts may need to determine the market value of a company and make suitable equity investments.
- A business’s board of directors can use this information to determine the business’s valuation for financial statements accurately.
While similar, shareholder equity is not the same thing as liquidation value. The company’s liquidation value is affected by the asset values of physical things like equipment or supplies.
Related: Debt vs. Equity Financing: Which Way Should Your Business Go?
Shareholders’ equity example
Here’s an example of shareholders’ equity:
Imagine that you have Company A, with total assets of $3 million. You have total liabilities of $1.2 million. If the company was liquidated, and its assets turned into $3 million, you would use some of that money to pay off the $1.2 million in liabilities.
What does that leave the shareholders? Approximately $1.8 million.
What components are included in shareholders’ equity?
For any given company, shareholders’ equity could be comprised of many different components. These include:
- Stock components, such as common, preferred and treasury stocks.
- Retained earnings — this is the percentage of net earnings not paid to shareholders as dividends (yet).
- Unrealized gains and losses.
- Contributed capital.
- Physical assets like business equipment and products.
When calculating shareholders’ equity using either of the below two formulas, it’s essential to add up all of these components when calculating the total asset value of a firm.
Related: Use a Balance Sheet to Evaluate the Health of Your Business
Positive vs. negative shareholders’ equity
Things can even get a little more complicated. There are positive and negative types of equity.
Positive shareholders’ equity means a company has enough assets to cover its debts or liabilities. Negative shareholders’ equity, on the other hand, means that the liabilities of a firm exceed its total asset value.
If the shareholders’ equity in a company stays negative, the balance sheet may display it as insolvent. In other words, the company could not liquidate itself and all of its assets and still pay off its debts, which could spell financial trouble for investors, shareholders, business owners and executives.
Many investors look at companies with negative shareholder equity as risky investments. While shareholder equity isn’t the only indicator of the financial hole for a company, you can use it in conjunction with other metrics or tools. When used with those tools, investors and potential shareholders can get a more accurate picture of the financial health of almost any enterprise.
While retained earnings are an essential part of shareholders’ equity (as the current percentage of net earnings is not given to shareholders as dividends), they should not be confused with liquid assets like cash. You can use several years of retained earnings for assets, expenses or other purposes to grow a business. It’s not “realized” cash at the moment.
How to calculate equity for shareholders
Fortunately, calculating equity for shareholders is relatively straightforward. Remember, equity is just the total asset value of the company minus its liabilities. You can calculate shareholder equity using the information found on any corporate balance sheet.
Here’s the formula:
Shareholder equity = total assets – total liabilities
Also called the balance sheet or accounting equation, the shareholder equity equation is one of the most critical tools when analyzing the company’s health.
Here’s how to calculate shareholder equity step-by-step:
- First, determine the company’s total assets on the balance sheet for a given period, such as one fiscal year. Be sure to add up all these assets carefully and correctly, or use an up-to-date balance sheet.
- Next, add up all of the total liabilities. Any up-to-date balance sheet should include this information. Liabilities include debts and outstanding expenses.
- Then determine the total shareholder equity, and add that number to the total liabilities.
- The remaining assets should equal the sum of total shareholder equity and liabilities.
A note when calculating total assets includes both current and noncurrent assets. If you aren’t aware, current assets are any assets you can convert to cash within one fiscal year.
This includes cash, inventory and accounts receivable. Noncurrent or long-term assets you can’t convert into cash in the same timeframe, such as patents, property and plant and equipment (PPE).
A note when calculating total liabilities: Liabilities also include both current and long-term liabilities. In keeping with the above, current liabilities are any debts due within one year, such as accounts payable or outstanding taxes.
Long-term liabilities are any debts or other obligations due for repayment later than one year in advance, such as leases, bonds payable and pension obligations.
Related: How to Protect Your Personal Finances From Business Risks
The above shareholder equity formula should serve you well in most cases. Still, there’s a secondary formula that might be helpful as well.
Here’s the secondary formula:
Shareholders’ equity = share capital + retained earnings – treasury stock
This “share capital method” of calculating shareholders’ equity is also known as the investor’s equation. This formula sums up all the retained earnings of a business and the share capital, then subtracts treasury shares.
The retained earnings in this formula are the sum of a company’s total or cumulative profits after they pay dividends. Most shareholders receive balance sheets that display this number in the “shareholders’ equity” section.
This formula can give a slightly more accurate picture of what shareholders may expect if forced/decided to liquidate a company or exit. However, you can use both formulas to calculate equity for shareholders equally well.
The value of equity for shareholders
Equity is essential for shareholders for several reasons.
For starters, shareholder equity tells you the total return on investment versus the amount invested by equity investors.
Ratios such as return on equity, or ROE (the company’s net income divided by shareholder equity), can be used to measure how well the management team for a company uses equity from investors to generate a profit. ROE can tell investors how capable current executives are at taking investment cash and turning it into more money.
A company with positive shareholders’ equity has enough assets to cover liabilities. In an emergency, shareholders or investors could theoretically exit without taking substantial financial losses.
As mentioned earlier, you can also use SE with other financial metrics or ratios to accurately determine whether a company is a wise investment.
These metrics include share price, capital gains, real estate value, the company’s total assets and other vital elements of private companies. Because equity is essential for shareholders, it’s also crucial for business owners and people on executive boards to calculate.
Furthermore, equity affects the value of startups on the stock market. Suitable asset allocation will help businesses grow, resulting in a higher amount of money from stock purchasers and ETF managers.
Return on equity in detail
Here’s a deeper dive into return on equity. Analysts and investors use this metric to determine if a company uses equity or investment cash to profit efficiently and effectively.
Say that you have a choice to invest in a company and want to check out its return on equity before making a decision. You look at the company’s balance sheet and figure out that the return on equity is 12% and has stayed at 12% for several years.
Related: Debt vs. Equity Financing: Which Way Should Your Business Go?
That’s a pretty good return on any investment. It may indicate that the company is worth putting your own money into.
On the other hand, if the return on equity is low, like 1%, and the current shareholders’ equity for a company is negative, it’s a surefire sign that your investment dollars will be worth more if you invest them elsewhere.
Calculating equity is essential when propositioning investors for more funding and advising your shareholders. Now you know how to calculate equity for shareholders with two distinct formulas.
Looking for more resources to expand your professional financial knowledge? Explore Entrepreneur’s Money & Finance guides here