What it means
A business is funded by two kinds of people: those who lend to it and those who own it. Lenders are promised repayment with interest and are paid first.
Owners are promised nothing; they receive whatever is left after every other claim has been met, in good years and bad. Equity is the accounting measure of that residual claim, which is why the balance sheet derives it as assets minus liabilities rather than listing it independently.
The components tell a story. Share capital (and share premium) is what shareholders paid when shares were issued.
Retained earnings are the cumulative profits kept in the business since it began, less all dividends paid; they are usually the largest component in a mature company and show how much of the business's growth was self-funded. Reserves record specific items such as asset revaluations and currency translation differences that bypass the income statement.
Treasury shares, bought back and held by the company, reduce equity. In a group, non-controlling interests show the share of subsidiaries owned by outside investors.
Equity is not cash and it is not market value. A company with $50 million of equity may have $2 million in the bank, because the rest is invested in buildings, stock and receivables.
Its shares may trade at $500 million if investors expect strong future profits, or $30 million if they do not. Book equity records what has been put in and retained at historical cost; market equity records what investors will pay for the future.
Equity is the business's shock absorber. Losses reduce it; if losses exceed it, liabilities exceed assets and the business is insolvent on a balance sheet basis.
That is why lenders look at the ratio of debt to equity, why regulators require banks to hold minimum equity against their assets, and why a business that pays out all its profits as dividends leaves itself nothing to absorb a bad year.
In practice
Real-world examples.
Example
A founder invests $100,000 and the business earns $40,000 in its first year and pays no dividend; equity at year end is $140,000.
Example
A listed company with $5 billion of equity buys back $1 billion of its own shares, reducing equity to $4 billion and increasing its debt-to-equity ratio.
Example
A start-up that has raised $10 million and lost $8 million has equity of $2 million; it must raise more before the losses exhaust what remains.
Think of it
“Equity is like the portion of your home you actually own. If your house is worth $300,000 and you owe $200,000 on the mortgage, your equity is $100,000.
Formula
Calculation
Equity = Total Assets minus Total Liabilities
Equity = Share Capital + Share Premium + Retained Earnings + Other Reserves minus Treasury Shares
Closing Retained Earnings = Opening Retained Earnings + Net Profit minus Dividends
Return on Equity = Net Profit / Average Equity x 100%
Worked example. A manufacturing company's position over a year:
- Opening equity: share capital $2,000,000; share premium $3,000,000; retained earnings $9,000,000; total $14,000,000
- During the year: net profit $2,400,000; dividends paid $900,000; new shares issued for $1,500,000 (nominal $300,000, premium $1,200,000); a revaluation of the factory adds $800,000 to a revaluation reserve
Closing equity:
- Share capital = $2,000,000 + $300,000 = $2,300,000
- Share premium = $3,000,000 + $1,200,000 = $4,200,000
- Retained earnings = $9,000,000 + $2,400,000 minus $900,000 = $10,500,000
- Revaluation reserve = $800,000
- Total equity = $17,800,000
Check against the balance sheet: total assets $31,000,000 minus total liabilities $13,200,000 = $17,800,000.
Return on equity = $2,400,000 / average of ($14,000,000 and $17,800,000) = $2,400,000 / $15,900,000 = 15.1%.
If the company has 2,300,000 shares in issue, book value per share is $17,800,000 / 2,300,000 = $7.74. If the shares trade at $19.35, the market values the company at 2.5 times book equity.Case study
Seen in the real world.
A profitable distribution company had paid out virtually all of its profits to its two owners for fifteen years. Equity stood at $400,000 against total assets of $6 million; suppliers and the bank funded the other 93%. When a major customer failed owing $700,000, the write-off exceeded the company's entire equity, the balance sheet showed negative net assets, and the bank called in its facility under a net worth covenant.
The business was solvent on a cash flow basis, still profitable and still had loyal customers, but it had no cushion. The owners injected $1 million of personal funds as new share capital, restored positive equity, and negotiated a new facility with a covenant requiring equity of at least 25% of total assets.
They now retain half of each year's profit. Their accountant's summary was that dividends had been paid from a balance sheet that could not afford them.
Watch out
Common mistakes.
- Confusing equity with cash. Equity is a claim on all the assets, most of which are not cash.
- Confusing book equity with market value. Book equity is historical cost less liabilities; market value is what investors will pay.
- Distributing all profits and leaving no retained equity to absorb losses.
Questions
People also ask.
What is the difference between equity and capital?
Share capital is the amount shareholders paid for their shares. Equity is share capital plus retained earnings and reserves, the owners' total stake.
Can equity be negative?
Yes, when liabilities exceed assets, usually after sustained losses or debt-funded buybacks. The company is then balance-sheet insolvent, though it may continue trading if it can pay its debts as they fall due.
Why does return on equity matter?
It measures the profit generated on the owners' money, which is what they invested to earn. It should exceed what they could earn elsewhere at similar risk.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%