What is equity capital

Difference Between Equity and Capital

May 10, 2012 Posted by Admin

Equity vs Capital

Equity and capital are both terms used to describe the ownership or monetary interest in the company that is held by the company’s owners. The meaning of both terms can vary according to the context for which they are used and the application varies depending on the subject matter being discussed. Equity and capital are terms so closely related to each other that they are often misunderstood to be the same. The following article represents a clear overview of the two and outlines their differences.

What is Capital?

Capital in the usual context of accounting and finance means the amount of funds that is contributed by the owners or investors of the business, to purchase assets or capital equipment required for the running of the business. Capital is also divided into financial capital, real or economic capital, shareholder’s capital, etc.

Financial capital is usually used to refer to the financial and monitory wealth that is accumulated and saved in order to start up a business or for investment in an existing business. Financial capital is further subcategorized into productive capital that is used in the day to day operations of the business and regulatory capital which is usually held by a business due to regulatory capital requirements enforced by law.

Real or economic capital, on the other hand, refers to goods that are purchased by businesses for use in production of other goods. For example, tools and machinery used in the production of cars would be real or economic capital for the business.

What is Equity?

Equity represents the claim that shareholders have, once the liabilities have been reduced from business assets. When assets exceed liabilities, positive equity exists and in the case that liabilities are higher than assets, the company will have a negative equity.

Taking an example; a house for which no debt remains is the owner’s equity, as the owner has complete ownership over the house and can sell it as he pleases. Equity may also refer to ‘shareholder’s equity’ which is the proportion of equity investment held by a shareholder depending on the value of the shares purchased and held.

Capital vs Equity

The similarity between equity and capital is that they both represent interest that owners hold in a business whether it is funds, shares or assets. Furthermore, capital is used in calculation when deriving the value of equity, as shareholders equity is the sum total of financial capital contributed by the owners and the retained earnings in the balance sheet.

Measuring the ownership interest held in a business in terms of equity may give a clearer picture as it shows the actual value once liabilities have been reduced.

What is the difference between Equity and Capital?

• Equity and capital are both terms used to describe the ownership or monetary interest in the company that is held by the company’s owners.

• Capital in the usual context of accounting and finance means the amount of funds that is contributed by the owners or investors of the business, to purchase assets or capital equipment required for the running of the business.

• Equity represents the claim that shareholders have, once the liabilities have been reduced from business assets. When assets exceed liabilities, positive equity exists and in the case that liabilities are higher than assets, the company will have a negative equity.

• In accounting terms, shareholders equity is the sum total of financial capital contributed by the owners and the retained earnings in the balance sheet.

Equity

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What Is Equity?

Equity, typically referred to as shareholders’ equity (or owners’ equity for privately held companies), represents the amount of money that would be returned to a company’s shareholders if all of the assets were liquidated and all of the company’s debt was paid off in the case of liquidation. In the case of acquisition, it is the value of company sales minus any liabilities owed by the company not transferred with the sale.

In addition, shareholder equity can represent the book value of a company. Equity can sometimes be offered as payment-in-kind. It also represents the pro-rata ownership of a company’s shares.

Equity can be found on a company’s balance sheet and is one of the most common pieces of data employed by analysts to assess a company’s financial health.

Key Takeaways

Equity

How Shareholder Equity Works

By comparing concrete numbers reflecting everything the company owns and everything it owes, the «assets-minus-liabilities» shareholder equity equation paints a clear picture of a company’s finances, easily interpreted by investors and analysts. Equity is used as capital raised by a company, which is then used to purchase assets, invest in projects, and fund operations. A firm typically can raise capital by issuing debt (in the form of a loan or via bonds) or equity (by selling stock). Investors usually seek out equity investments as it provides a greater opportunity to share in the profits and growth of a firm.

Equity is important because it represents the value of an investor’s stake in a company, represented by the proportion of its shares. Owning stock in a company gives shareholders the potential for capital gains and dividends. Owning equity will also give shareholders the right to vote on corporate actions and elections for the board of directors. These equity ownership benefits promote shareholders’ ongoing interest in the company.

Shareholder equity can be either negative or positive. If positive, the company has enough assets to cover its liabilities. If negative, the company’s liabilities exceed its assets; if prolonged, this is considered balance sheet insolvency. Typically, investors view companies with negative shareholder equity as risky or unsafe investments. Shareholder equity alone is not a definitive indicator of a company’s financial health; used in conjunction with other tools and metrics, the investor can accurately analyze the health of an organization.

Formula and How to Calculate Shareholders’ Equity

The following formula and calculation can be used to determine the equity of a firm, which is derived from the accounting equation:

This information can be found on the balance sheet, where these four steps should be followed:

Shareholder equity can also be expressed as a company’s share capital and retained earnings less the value of treasury shares. This method, however, is less common. Though both methods yield the exact figure, the use of total assets and total liabilities is more illustrative of a company’s financial health.

What the Components of Shareholder Equity Are

Retained earnings are part of shareholder equity and are the percentage of net earnings that were not paid to shareholders as dividends. Think of retained earnings as savings since it represents a cumulative total of profits that have been saved and put aside or retained for future use. Retained earnings grow larger over time as the company continues to reinvest a portion of its income.

At some point, the amount of accumulated retained earnings can exceed the amount of equity capital contributed by stockholders. Retained earnings are usually the largest component of stockholders’ equity for companies operating for many years.

Treasury shares or stock (not to be confused with U.S. Treasury bills) represent stock that the company has bought back from existing shareholders. Companies may do a repurchase when management cannot deploy all of the available equity capital in ways that might deliver the best returns. Shares bought back by companies become treasury shares, and the dollar value is noted in an account called treasury stock, a contra account to the accounts of investor capital and retained earnings. Companies can reissue treasury shares back to stockholders when companies need to raise money.

Many view stockholders’ equity as representing a company’s net assets—its net value, so to speak, would be the amount shareholders would receive if the company liquidated all of its assets and repaid all of its debts.

Example of Shareholder Equity

Using a historical example below is a portion of Exxon Mobil Corporation’s (XOM) balance sheet as of September 30, 2018:

The accounting equation whereby Assets = Liabilities + Shareholder Equity is calculated as follows:

Other Forms of Equity

The concept of equity has applications beyond just evaluating companies. We can more generally think of equity as a degree of ownership in any asset after subtracting all debts associated with that asset.

Below are several common variations on equity:

Private Equity

When an investment is publicly traded, the market value of equity is readily available by looking at the company’s share price and its market capitalization. For private entities, the market mechanism does not exist, so other valuation forms must be done to estimate value.

Private equity generally refers to such an evaluation of companies that are not publicly traded. The accounting equation still applies where stated equity on the balance sheet is what is left over when subtracting liabilities from assets, arriving at an estimate of book value. Privately held companies can then seek investors by selling off shares directly in private placements. These private equity investors can include institutions like pension funds, university endowments, insurance companies, or accredited individuals.

Private equity is often sold to funds and investors that specialize in direct investments in private companies or that engage in leveraged buyouts (LBOs) of public companies. In an LBO transaction, a company receives a loan from a private equity firm to fund the acquisition of a division of another company. Cash flows or the assets of the company being acquired usually secure the loan. Mezzanine debt is a private loan, usually provided by a commercial bank or a mezzanine venture capital firm. Mezzanine transactions often involve a mix of debt and equity in a subordinated loan or warrants, common stock, or preferred stock.

Private equity comes into play at different points along a company’s life cycle. Typically, a young company with no revenue or earnings can’t afford to borrow, so it must get capital from friends and family or individual «angel investors.» Venture capitalists enter the picture when the company has finally created its product or service and is ready to bring it to market. Some of the largest, most successful corporations in the tech sector, like Google, Apple, Amazon, and Meta—or what is referred to as GAFAM—began with venture capital funding.

Types of Private Equity Financing

Venture capitalists (VCs) provide most private equity financing in return for an early minority stake. Sometimes, a venture capitalist will take a seat on the board of directors for its portfolio companies, ensuring an active role in guiding the company. Venture capitalists look to hit big early on and exit investments within five to seven years. An LBO is one of the most common types of private equity financing and might occur as a company matures.

A final type of private equity is a Private Investment in a Public Company (PIPE). A PIPE is a private investment firm’s, a mutual fund’s, or another qualified investors’ purchase of stock in a company at a discount to the current market value (CMV) per share to raise capital.

Home Equity

Home equity is roughly comparable to the value contained in homeownership. The amount of equity one has in their residence represents how much of the home they own outright by subtracting from the mortgage debt owed. Equity on a property or home stems from payments made against a mortgage, including a down payment and increases in property value.

Home equity is often an individual’s greatest source of collateral, and the owner can use it to get a home equity loan, which some call a second mortgage or a home equity line of credit (HELOC). An equity takeout is taking money out of a property or borrowing money against it.

Brand Equity

When determining an asset’s equity, particularly for larger corporations, it is important to note these assets may include both tangible assets, like property, and intangible assets, like the company’s reputation and brand identity. Through years of advertising and the development of a customer base, a company’s brand can come to have an inherent value. Some call this value «brand equity,» which measures the value of a brand relative to a generic or store-brand version of a product.

There is also such a thing as negative brand equity, which is when people will pay more for a generic or store-brand product than they will for a particular brand name. Negative brand equity is rare and can occur because of bad publicity, such as a product recall or a disaster.

Equity vs. Return on Equity

Return on equity (ROE) is a measure of financial performance calculated by dividing net income by shareholder equity. Because shareholder equity is equal to a company’s assets minus its debt, ROE could be considered the return on net assets. ROE is considered a measure of how effectively management uses a company’s assets to create profits.

Equity, as we have seen, has various meanings but usually represents ownership in an asset or a company, such as stockholders owning equity in a company. ROE is a financial metric that measures how much profit is generated from a company’s shareholder equity.

What Is Equity in Finance?

Equity is an important concept in finance that has different specific meanings depending on the context. Perhaps the most common type of equity is “shareholders’ equity,» which is calculated by taking a company’s total assets and subtracting its total liabilities.

Shareholders’ equity is, therefore, essentially the net worth of a corporation. If the company were to liquidate, shareholders’ equity is the amount of money that would theoretically be received by its shareholders.

What Are Some Other Terms Used to Describe Equity?

Other terms that are sometimes used to describe this concept include shareholders’ equity, book value, and net asset value. Depending on the context, the precise meanings of these terms may differ, but generally speaking, they refer to the value of an investment that would be left over after paying off all of the liabilities associated with that investment. This term is also used in real estate investing to refer to the difference between a property’s fair market value and the outstanding value of its mortgage loan.

How Is Equity Used by Investors?

Equity is a very important concept for investors. For instance, in looking at a company, an investor might use shareholders’ equity as a benchmark for determining whether a particular purchase price is expensive. If that company has historically traded at a price to book value of 1.5, for instance, then an investor might think twice before paying more than that valuation unless they feel the company’s prospects have fundamentally improved. On the other hand, an investor might feel comfortable buying shares in a relatively weak business as long as the price they pay is sufficiently low relative to its equity.

How Is Equity Calculated?

Equity is equal to total assets minus its total liabilities. These figures can all be found on a company’s balance sheet for a company. For a homeowner, equity would be the value of the home less any outstanding mortgage debt or liens.

Equity Vs. Capital: 6 Differences You Should Know

In the world of finance, equity refers to any money companies generate through their shareholders or businesses through their owners. Equity is a type of finance that companies use when starting up and down the line when they need funds.

However, there’s also another word that people often use called capital. While these are similar terms that describe funds, they are also different due to several reasons.

The top 6 differences between equity and capital are as below.

1) Definition

Equity is a term used in finance to describe shareholders’ equity of a company. The definition of equity in the world of finance is the amount of money that the company’s shareholders will get if a company liquidates after it pays off all its debts using its assets. In other words, equity is the residual amount after deducting the liabilities of a company from its assets.

Capital is a word associated with different aspects of a business. Most commonly, capital refers to the injection of funds into a business by its owner. For companies, it comes in the form of paid-in capital, also known as share capital.

2) Profits

When the owner of a business invests in it, they expect to make profits. While the investment is its capital, the earnings aren’t. In contrast, profits make a part of the equity of a business.

If the owner or shareholder chooses to reinvest the money in the business or company, then it qualifies as capital. Therefore, any returns that shareholders get that the company uses are not capital.

On the other hand, if the owner does not reinvest in the money or withdraw it, then the earnings stay within the business. In that case, the profits become retained earnings and are a part of equity rather than capital.

3) Losses

When a company makes losses, it results in a decrease in its equity. Therefore, the rights of its shareholder also decrease. However, losses do not affect the capital of a company or business.

For companies, losses do not impact share capital or share premium. Therefore, it only affects the shareholders’ equity of a company.

On the other hand, for normal businesses, losses don’t affect the owners’ capital or investment in them. The capital of the business will remain the same, even if it goes into losses. Similarly, companies or businesses cannot replace their losses with capital and vice versa.

4) Reserves

Equity also includes other reserves of a company. For example, companies may consist of ‘other reserves’ on their Balance Sheet. These reserves also cover several items created from shareholders’ contributions or profits.

However, these reserves are not a part of the capital of a business, which represents the owners’ or shareholders’ investments in it.

In contrast, reserves make up a part of the equity of a company. Almost all large companies have some reserves in their shareholders’ equity portion of their Balance Sheets.

In some cases, these reserves may also include non-monetary amounts. Overall, reserves aren’t a part of the capital of a company but its equity.

5) Revaluation surplus

Another item that is often common in the Balance Sheet of companies is revaluation surplus. Usually, companies that use the fair value method of valuing their assets also have a revaluation surplus due to it.

A revaluation surplus is a non-monetary amount. Similarly, it is a part of a company’s equity because it does not relate to the shareholders.

Therefore, the revaluation surplus is another differentiating factor between capital and equity. While the equity of a company may contain a revaluation surplus, its capital may not.

As mentioned, the main reason for it is that it does not generate from the shareholders of a company but due to its accounting policies and assets used.

6) How they are present in the balance sheet

There are three main elements of financial statements in the balance sheet. They are assets, liabilities, and equity.

In the balance sheet, capital is the subcategories of equity element where equity includes many other items besides capital and share premiums, such as retained earnings or accumulated loss, as well as reservice.

7) Other usages

Equity, as mentioned above, only refers to the shareholders’ rights in a company or owners’ rights in a business. Similarly, capital only represents the investment made in the company or business directly.

However, the word capital also has another usage. It is a word that also describes the overall finance structure of a company.

Therefore, capital is also a term used to describe both the equity and debt of a company. For example, in financial management, capital structure or cost of capital don’t describe investments of owners but the overall finance structure of the company.

Equity Capital

Equity Capital Meaning

Equity Capital refers to the capital collected by a company from its owners and other shareholders in exchange for a portion of ownership in the company. The company is not liable to repay the fund raised through equity financing.

It is one of the primary sources through which businesses obtain capital to finance their operations and overall development. The most common ways to raise equity funds are through a public and private issue of shares, and accordingly, it is also classified into private and public equity capital.

Table of contents

Key Takeaways

How to Calculate Equity Capital Cost?

Total Equity = Total Assets – Total liabilities

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For eg:
Source: Equity Capital (wallstreetmojo.com)

Example

Advantages and Disadvantages

As with any investment, several advantages and disadvantages are associated with equity fund.

The advantages are:

It has several disadvantages as well, including:

Frequently Asked Questions (FAQs)

Capital is an essential component for managing business operations and growth. It is generally classified into equity capital, debt capital, and working capital. The proper proportion of debt and equity in the capital structure ensures the business’s financial strength.

Equity Capital Markets (ECM) refers to a platform where companies, with the help of other financial entities, raise capital through equity financing. ECM allows a wide array of activities like marketing, distribution, and allocation of issues. Moreover, it mainly includes primary equity issues like private placements and IPOs and secondary market issues like stock exchanges, over-the-counter markets (OTC).

No, equity is not an asset. The quantitative value of equity is derived by deducting liabilities from assets. Equities are more like liabilities since they are attributable to the investors, unlike assets owned by the business or company.

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What is Equity Capital?

Equity capital is funds paid into a business by investors in exchange for common or preferred stock. This represents the core funding of a business, to which debt funding may be added. Once invested, these funds are at risk, since investors will not be repaid in the event of a corporate liquidation until the claims of all other creditors have first been settled. Despite this risk, investors are willing to provide equity capital for one or more of the following reasons:

Owning a sufficient number of shares gives an investor some degree of control over the business in which the investment has been made.

The investee may periodically issue dividends to its stockholders.

The price of the shares may appreciate over time, so that investors can sell their shares for a profit.

From a valuation perspective, equity capital is considered to be the net amount of any funds that would be returned to investors if all assets were to be liquidated and all corporate liabilities settled. In some cases, this may be a negative figure, since the market value of company assets may be lower than the aggregate amount of liabilities.

Accounting for Equity Capital

From an accounting perspective, equity capital is considered to be all components of the stockholders’ equity section of the balance sheet, which includes the par value of all stock sold, additional paid-in capital, retained earnings, and the offsetting amount of any treasury stock (repurchased shares).

Debt Financing

An alternative form of capital is debt financing, where investors also pay funds into a business, but expect to be repaid along with interest at a future date. A variation is convertible debt, where investors can convert their debt holdings into the shares of the borrower; this is a valuable option for investors when the borrower has a strong upside to its projected profitability.