Equity (Shareholders' Equity)
1. Definition
Equity, also known as Shareholders' Equity or Net Assets, represents the residual interest in the assets of an entity after deducting all its liabilities.
It is the amount that would be returned to shareholders if all the company's assets were liquidated and all its debts were repaid.
2. The Basic Equation
Rearranging the accounting equation shows the true nature of equity:
$$ \text{Equity} = \text{Assets} - \text{Liabilities} $$
3. Key Components
Equity essentially comes from two sources: money invested by owners and money earned by operations.
A. Paid-in Capital (Contributed Capital)
- Common Stock (Share Capital): The par value of the shares issued to investors.
- Additional Paid-in Capital (APIC): The amount paid by investors above the par value of the stock.
B. Retained Earnings
- The cumulative net income that has been retained for reinvestment in the business rather than distributed as dividends. This reflects the company's internal growth.
C. Accumulated Other Comprehensive Income (AOCI)
- Unrealized gains or losses that are excluded from net income (e.g., foreign currency translation adjustments).
D. Treasury Stock
- Stock that the company has repurchased from the open market. This reduces total equity and is recorded as a negative number.
4. Key Principle: Residual Claim
- Last in Line: In the event of bankruptcy or liquidation, creditors (debt holders) have the first claim on assets. Shareholders have a residual claim, meaning they get whatever is left over.
5. Why It Matters
- Book Value: Equity represents the accounting value (book value) of the company. It is used to calculate the Price-to-Book (P/B) ratio.
- Financial Health: A healthy level of equity provides a cushion against losses. Negative equity implies the company's liabilities exceed its assets (technical insolvency).
- Return on Equity (ROE): It is the denominator in the ROE calculation, which measures how efficiently management is using shareholders' capital to generate profits.