The amount of equity in a business is one of the most important indicators of a company's financial health. Owners and stockholders rely on this measure to determine how much the business is really worth. Additionally, it helps investors decide how much money to invest in the company. Equity is a relationship between assets and liabilities, which are all shown on the balance sheet.
Definition of Equity
The equity in a business is the amount that would be left over if the owners were to sell all of the company's assets and use the proceeds to pay off the liabilities. The values of both the asset and liability accounts affect the owner's equity in the business. Equity is the amount of money that the owners originally invested, with any profits added and losses subtracted since the business began.
Equity on the Balance Sheet
Equity on a balance sheet is shown near the bottom of the balance sheet reported in columns, with the balance reported in the right-hand column, or the same column where liabilities are reported. If the business uses a T-shaped balance sheet, equity is reported on the right side of the "T," directly under the total of liabilities. It may be listed as "shareholder's equity" for a corporation.
Debt-to-equity ratio is a critical measure of a company's condition when tracked over time. It is calculated by dividing total debt by total equity and multiplying by 100 to show it as a percentage. The debt-to-equity ratio of a business reflects how much of the business is financed by the owners or investors and how much is financed by creditors. It is viewed as a key indicator of financial strength. If the debt-to-equity ratio increases over time, the business growth is being funded more by creditors than by retained earnings or investment by the owners, which is a dangerous trend.
Intangible Assets and Equity
When evaluating a business, a person must also consider the relationship between intangible assets and equity. A business may carry intangible assets on its balance sheet that are difficult to value. Examples include patent rights and copyrights, as well as goodwill, which is the value that the owners give to the company's good name or brand value. If intangible assets make up a large percentage of the equity shown on the balance sheet, a potential investor should evaluate these assets closely to determine whether they are valued accurately or inflated to make the business more desirable by increasing equity.
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