What Is Equity


What is equity?

Equity is the amount that the owners put into the company, and which is the difference between assets and liabilities.

Understanding what is equity?

Equity is simply the amount that shareholders have invested in the company, and it is the difference between assets and liabilities in the balance sheet.

This capital is considered the company’s own money, but can also be seen as the shareholders’ capital (alternatively the company’s debt to the owners).

However, we can develop the definition above a little more than that.

Equity is the total amount of capital that the shareholders have invested (share capital and other contributions afterwards), plus the company’s earnings (gains and losses), minus the shareholders’ withdrawals from the company (eg through dividends).

In the annual report, the administration report shall report on how the equity has changed from the previous financial year.

The company’s balance sheet includes its assets on the one hand, and liabilities and equity on the other. And as we mentioned earlier, equity is the difference between these two sides (assets minus liabilities).

The reason why this capital is reported on the credit side (minus side) of a balance sheet is because it is interpreted as a liability to the owners.

Equity is a component that is used in several different key figures. Some examples of key figures are the ROE number, the ROIC number, the ROCE number, and the ROA number – and all of these are used when you want to analyze the profitability of a company.

Equity in the company’s balance sheet

The equity consists of the capital that the owners have invested in the company.

This includes start-up capital but also capital contributions that have been invested in arrears, as well as gains that remain after dividends or own withdrawals.

A company’s balance sheet is arranged in two columns, with assets on one side, and liabilities and equity on the other side.

Equity is consequently the difference between assets and liabilities.

Equity is found on the credit side (minus side) in the balance sheet, as it can be interpreted as a liability to the company’s owner.

Changes in equity

If the result for the year is positive, equity is also affected in a positive direction. By the owners reinvesting profits in the company, the equity is strengthened.

Equity can be decisive for how the company manages in the event of worse times.

When equity is strengthened, the business’s self-financing also increases, and dependence on creditors decreases.

A deficit (loss) in the company leads to a decrease in equity or even a negative one. A negative equity means that the liabilities exceed the value of the assets.

As a rule, a lack of capital is due to the company making a loss, but it can also be due to the owners making large withdrawals instead of reinvesting profits in the company.

Equity for sole traders, trading companies and limited partnerships

In a sole proprietorship, trading company and limited partnership, the trader or co-owners can continuously book their own deposits, which increases equity, and book their own withdrawals, which reduces equity.

In connection with the company making financial statements, the profit for the year is booked in equity.

If the result for the year is positive, the value of equity increases and if the result is negative, the value of equity decreases.

Equity for limited companies and economic associations

In limited companies and economic associations, a distinction is made between restricted equity and unrestricted equity.

Restricted capital must be used within the company, and must therefore not be used for dividends.

For a limited company, the restricted capital consists largely of share capital, reserve fund and revaluation fund. Restricted equity for an economic association consists primarily of the members’ contributions, revaluation fund and reserve fund.

The rest of the equity, so-called unrestricted equity, is freely available to the company’s owners, for example for dividends to shareholders.

Unrestricted equity includes retained earnings and profit for the year.

According to the Annual Accounts Act (1995: 1554), it applies to both limited companies and economic associations that the equity must be divided into restricted equity and unrestricted equity or accumulated loss.

For the same company forms, it also applies that changes in equity compared with the previous year’s balance sheet must be specified.

How does equity arise?

The key figure equity arises when the owners of a company, or the stakeholders in a business, contribute money to the business.

It can also occur when the business generates its own profit. If the business instead generates a loss, equity decreases. Equity decreases even if a company pays a dividend.

Restricted equity and unrestricted equity

In Sweden, equity is classified into two categories: restricted equity and unrestricted equity.

Restricted equity may only be used within the business. It may thus not be distributed to shareholders through dividends.

This category includes e.g. share capital, reserve fund, and revaluation fund.

Unrestricted equity may be disposed of freely. It is thus permitted to distribute this capital to the shareholders, but not so much that it harms the company and its operations.

This category includes the sum of retained earnings, profit for the year, and contributions from shareholders.

Restricted equity and unrestricted equity

A distinction is made between two different types of equity; unrestricted equity and restricted equity. The restricted equity in a company consists of the share capital, reserve fund and revaluation fund.

The share capital is the funds that have been contributed in total to the company by its shareholders either as start-up capital or as shareholder contributions.

The restricted equity may only be used within the business, thus it may not be distributed to the owners or stakeholders.

Unrestricted equity consists of the operating surplus, its profit. Unrestricted equity can be used within the business, but it may also be used for dividends to the owners.

When distributing profits in a limited company, however, the precautionary principle applies. This means that the entire unrestricted equity is not necessarily available for share dividends.

When assessing how much of the unrestricted equity may be distributed, one must look at the company’s need for financing in the future.

You may not distribute more than is possible with regard to the economic survival of the business.

What affects and changes equity?

There are a number of different factors that affect equity, so let’s go through them.

Limited company

  • Profit increases equity (if profits remain in the company)
  • Contributions from shareholders increase equity
  • Loss reduces equity
  • Dividends to shareholders reduce equity

Individual company

There are differences between individual companies and limited companies when it comes to equity.

Here there is no share capital, no division between restricted or unrestricted capital, nor any reserve fund.

Instead, the equity in an individual company consists of these sub-items:

  • Equity at the beginning of the year
  • Total sum of the company’s accumulated results
  • Total sum of deposits and withdrawals in previous years
  • This year’s own withdrawals (eg withdrawals, cash withdrawals, and taxes)
  • This year’s own deposits (eg cash, machinery, and equipment)
  • Profit for the year (profit increases equity, while loss decreases)

Trading companies and limited partnerships

The equity in these company forms looks the same as in a sole proprietorship, but here the capital items are reported at the individual level (divided among all shareholders in the company).

Each owner must therefore have the opportunity to follow their own deposits and withdrawals from the company.

Equity and borrowed equity

As mentioned above, equity is included on the liability side, as it can be regarded as borrowed from the business’s owners or stakeholders.

Usually, a business has also borrowed capital from banks, or other financiers.

A company or business with a high proportion of equity in relation to the borrowed capital is financially more secure (has a better credit rating) and also has the opportunity to borrow new funds at a lower interest rate than businesses with a lower proportion of equity.

The protection of equity

As part of the assessment when someone chooses to invest in a business or lend money to a business, they usually look at equity.

Therefore, it is important that there is protection for equity so that this does not disappear from one day to another.

Part of this protection is that the restricted equity may not be distributed to the owners.

The fact that the precautionary rule applies to the distribution of unrestricted equity also serves as a protection.

Liquidation obligation (bankruptcy or liquidation)

Furthermore, there are provisions regarding the liquidation obligation. If the equity is less than a company’s share capital, an obligation arises to prepare a so-called balance sheet.

If the equity is not restored after a period of respite, the company must go into liquidation.

If this does not happen, the board of a company may incur a personal payment obligation for the company’s debts.
In the event of liquidation or winding up of a business, all debts to outsiders must be settled before the owners or stakeholders have the right to receive any funds.

Equity improves the ability to survive

The company’s equity can be seen as a form of buffer, and it can therefore be a decisive factor how well they cope with bad times.

A lot of equity means a strong ability to survive. And a negative equity (liabilities exceed the value of assets) means an increased risk.

It is therefore important that the company builds up equity during the good times by reinvesting the profits.

In short, this leads to a reduction in dependence on banks and creditors, and that the proportion of debt and thus also interest costs can therefore be kept down. In this way, the business’s self-financing is improved.

Accounting accounts linked to equity

In Sweden, in accounting, different accounting accounts are used to categorize and structure everything in a good and clear way. This is usually done by using the BAS chart of accounts.

In that chart of accounts, the equity is booked in account class 2 (which is for liabilities and equity) and account group 20 (which is used for equity).

  • Account 2010–2059 for sole proprietorships and for partners in trading and limited partnerships
  • Account 2060–2079 for non-profit associations, foundations and denominations
  • Account 2080–2099 for limited companies and economic associations

Summary

Equity is an accounting term and constitutes the difference between the assets and liabilities in the balance sheet of a business.

A large proportion of equity in relation to borrowed capital means that a business is financially more stable and creditworthy.

Restricted equity may be used only for the business, while unrestricted equity may be distributed back to owners and stakeholders.

However, you must not distribute so much of the unrestricted capital that it damages the business.

Sources

https://www.degruyter.com/document/doi/10.1515/9780691214054/html

https://link.springer.com/article/10.1007/s11187-008-9098-x

https://www.emerald.com/insight/content/doi/10.1108/17508610680000714/full/html

https://academic.oup.com/ej/article-abstract/122/565/1262/5079501

Kevin

This article has been reviewed by our editorial board and has been approved for publication in accordance with our editorial policies.

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