What is Equity

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What is Equity? Equity is a term used in accounting, in real estate and home-ownership, in investing, as well as in startup financing and valuation. The meaning of the term equity is very similar in the various areas where it is used, so it will be good to review all four of these to get the best understanding.

In accounting, equity is a term that you will find on the balance sheet. What you own is on the left: assets. What you owe is on the right: liabilities and equity. Equity is the book value of the shareholder capital. The accounting equation tells you that assets equal liabilities plus equity. That also means that equity equals assets minus liabilities.

Equity on a balance sheet goes up when a company is profitable: the net income for the year gets added to equity through retained earnings. Equity on a balance sheet goes down when the company is loss-making (losses “eat up” the equity), or when the company pays a dividend to its shareholders.

Equity in home-ownership works very similar to equity on the balance sheet. What we own is on the left: the house worth $500.000. What we owe is on the right: $400.000 of mortgage loan from the bank, and the owner of the house, Jim, has $100.000 of equity in the house. Equity in home-ownership is what a home is worth minus how much you owe to the bank.

Just like equity on the balance sheet of a company can go up or down, the equity that you have in your home can go up or down. If Jim is paying down the mortgage on his house by $50.000, then the amount of the loan outstanding will decrease and his equity in the house will increase. If the market value of the house increases, then Jim’s equity in the house will increase. Remember that equity is what a home is worth minus how much you owe to the bank. If the market value of the house decreases, then Jim’s equity in the house will decrease, or even become negative. Jim will need to have a conversation with the bank to make a remediation plan to get back to positive equity, or in the worst case scenario Jim might lose the ownership of the house and the bank will need to take a partial write-off of its outstanding loan.

Investing in equity. Remember the example of the small manufacturing business that owned a machine, had a loan from a bank, and equity from one shareholder. What if we make that a big manufacturing business that owns lots of machines at different sites totaling $1 billion, has many loans outstanding totaling $800 million that are publicly traded in the bond market, and has many different shareholders as the certificates of ownership, the equity, is traded publicly as well. As an investor, you have the choice of buying bonds (which would have a predetermined interest rate, and has the machines as collateral), or the choice of buying stocks (which are perceived as having more downside risk as well as more upside potential). Invest in debt, or invest in equity.

Equity in a startup company. How do you put a “price” on what is essentially so far just an idea, that still has to be developed and will find many ups and downs along the way? The company does not have any assets, liabilities and equity yet. The financing and valuation depend on the estimate of the revenue, profit and cash flow that the business idea might bring in the future. A good way to learn about startup companies in the tech field is the comedy series “Silicon Valley”. What happens if the app you are developing turns out to have a great compression algorithm, you are courted by investors ready to fund you, and your friends and roommates suddenly become your employees while you become the CEO? In season one of “Silicon Valley”, landlord/incubator Erlich Bachman has 10% of the shares in startup company Pied Piper, eccentric billionaire Peter Gregory buys 5% for $200.000, and the three employees Gilfoyle, Dinesh and Jared get 3% each in what someday might be a multi-billion $ company. By my math, that sets the CEO Richard Hendricks up with 76% of the shares in the company. In subsequent seasons of the comedy series, Pied Piper goes through various rounds of financing, as well as acquisitions and other ownership changes.

Having equity can be a great thing. Equity has potential risks as well as potential rewards. The term equity is used in accounting, in home-ownership, in investing, and in start-up financing and valuation. Probably the easiest metaphor to remember is equity in home-ownership: what a home is worth minus how much you owe to the bank.

Philip de Vroe (The Finance Storyteller) aims to make strategy, #finance and leadership enjoyable and easier to understand. Learn the business and accounting vocabulary to join the conversation with your CEO at your company. Understand how financial statements work in order to make better #investing decisions. Philip delivers #financetraining in various formats: YouTube videos, classroom sessions, webinars, and business simulations. Connect with me through Linked In!

41 comments

    1. Thank you very much, Marinho! 🙂 Sounds like you have been watching some of my other videos as well. 😉

    2. @The Finance Storyteller Sure I did. I’m learning a lot with your videos.

      By the way, I would like to suggest a video about book recommendations to anyone interested in going deeper in this subject.

  1. “shareholder capital is owed to Jane the owner of the business” I guess if Jane owns 100% of shares

    1. Correct! Maybe I should have said “shareholder capital is owed to Jane, the sole owner of the business” to make that more clear. Thanks for pointing that out, Carley!

    1. Nice to hear that, Harry! Thank you. My mission is to make finance accessible, examples and explanations help with that.

  2. Key business knowledge right there. Don’t just be a goon and sign the dotted line without at least this basic information.

    1. Hello Raviteja! Sorry to hear that. Maybe you have already subscribed in the past (you cannot subscribe twice to the same channel), or you are not logged in to YouTube with your gmail account (please login and then subscribe), or there is an error on the website (reboot your computer, and try again later).

  3. Won’t the machine become a liability? From my understanding anything that has a depreciation cost to it, is considered as a liability.

    1. Hello Jagwant. Not sure where you got that information, but in conventional accounting standards in Europe and US, a machine is a fixed asset, and depreciation cost gets booked as debit to depreciation expense in the income statement, with the credit to the accumulated depreciation contra-asset account. The original amount in the fixed asset account minus the accumulated depreciation is the net book value. See also my video on depreciation https://www.youtube.com/watch?v=6SY8s1_OEro or the video on accumulated depreciation https://www.youtube.com/watch?v=iOdEVUS2_fc or the video on the accounting equation https://www.youtube.com/watch?v=OYql7Y9NnBg

    1. Thank you! Happy to hear that! My teenage kids help me with that (as well maintaining my Instagram channel).

  4. So equity is almost synonymous with just saying ownership? If you have equity on a house that’s your share you paid and that you own.

    1. Yep, pretty much. Equity in a house is what it is worth (market value) minus the loans/mortgage you have on it.

  5. Can anyone tell me what is the correct order of watching the finance storyteller videos in order to learn finance from scratch?… highly appreciated

    1. Hello Anmol! I would recommend to use the playlists for that. Finance for beginners https://www.youtube.com/watch?v=iR7b2NjgAO8&list=PLKbmcnUUQMlkG0hLUJ97hNk002YilQPzc and Accounting 101 https://www.youtube.com/watch?v=OYql7Y9NnBg&list=PLKbmcnUUQMlnWPLx9IeS-cYec2r7GzJ3S and Finance case studies https://www.youtube.com/watch?v=PI9X5Ybek_E&list=PLKbmcnUUQMlmMt9bnq6CruylRotpL8YOY Once you are in a video, cards (pop-up messages) will appear on the top right, with suggestions of related videos to watch. Also, the endscreen of every video has two suggestions of what to watch next. Hope this helps!

    1. You’re welcome! That’s exactly what I am aiming for! Please subscribe to the channel, and enjoy the library of videos that’s available.

  6. Does equity have a physical form when starting a company?is equity just a ownership registration to goverment?

  7. If I want to calculate the equity of a business from the profit and loss statement to use it later on for solvency analysis.
    Shall I use:
    Equity = Net Current Assets (Working Capital) – Total Liabilities
    or = Equity = Net Current Assets (Working Capital) – Current Liabilities
    (short-term)
    or Equity = Total Assets (Fixed and Current) – Total Liabilities

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