As a business grows, it's common to raise money from external sources. This could be privately, such as from friends and family, or private equity and venture capital investors; or it could be through publicly listing your company on a stock exchange. Over time, this means that several other entities will all own a stake in your business.
Calculating your business equity allows you to understand how much money you could pass on to all the investors in your company if the money you owe is fully repaid and your assets are sold. The amount each investor would receive from this pot depends on what percentage of stake they own.
"Understanding equity is valuable in helping you determine the success and stability of your business, as well as supporting financed growth," says Jonathan Barber, UK Executive Director for The Institute of Financial Accountants. “It is a good indicator of the profitability of the business, the potential value for investors and it can tell you the proportion of the business that belongs to shareholders or owners."
Understanding business equity
Business equity is the money returned to company investors after all debts are paid and assets liquidated. Simply put, it is the difference between a company's liabilities and its assets.
As businesses grow, they often raise funds from external sources like private investors or by going public. This means multiple parties end up owning a share in the business.
Determining your business equity provides insight into potential returns for each investor upon fulfilling all financial obligations and selling off assets. The return depends on the stake owned by each investor.
In this way, understanding the equity position of your company supports you in measuring profitability, making investment decisions, releasing additional funding through equity financing and even seeking independent investors, says Barber.
Lynis Bassett, Founder and CEO of Class People Foundation, an educational recruitment company, says her business is "cash-rich," which means she hasn't needed to raise external finance to fuel its growth, though she has considered equity financing in the past. Instead, Bassett, who currently owns 100% of Class People, is releasing 80% of her shares to her daughter and retaining the remainder, to keep the business in the family.
In this example, if Bassett were to sell all of her assets to pay off her liabilities, the remaining sum of money following this, the business equity, would be divided 20/80 between herself and her daughter.
Business equity components
Outstanding shares
This is the number of shares that have been sold to investors and not repurchased by the company. In other words, it is the total amount of shares owned by a company’s investors.
Additional paid-in capital
This is the amount of money paid for shares in a publicly listed stock above their stated par value. That is the nominal price of a stock determined at the time of its issue. Par value is usually the lowest price that a company will sell its shares for. Additional paid-in capital is the difference between the par value and the actual price that each stock sold for.
Retained earnings
Retained earnings are the percentage of your company’s net earnings that were not paid to its shareholders as dividends. You can think of this as the amount of profit a company has left after paying all its direct and indirect costs, taxes and dividends to shareholders. Companies often save retained earnings to pay off debt or re-invest in the business.
Treasury stock
Treasury stock is the shares a company has bought back from existing shareholders. A company may decide to repurchase shares and set them aside for a later time. For example, it could use them to raise funds for new opportunities, such as the acquisition of a competitor.
Positive equity vs. negative equity
When a company has more assets than it does liabilities, the business is considered to be profitable or to have positive equity. But when a company’s liabilities are higher than its assets, it is considered to be in negative equity, says Barber. In other words, the company owes more than it owns.
However, negative equity does not necessarily mean it's the end of the road for a business. “It is possible for a business to have temporary negative equity without being insolvent, such as when a large investment is made in new equipment, because equity is only a snapshot in time,” Barber shares.
Managing the equity position of your company means keeping on top of cash flow to ensure there's always enough cash to meet your liabilities as they fall due. The American Express® Business Gold Card gives you extended payment terms of up to 54 days so that cash stays in your bank for longer, giving you more time to make sales and pay your expenses on time¹.
The equity formula
Business equity is the difference between a company’s liabilities and assets, which means it is calculated by deducting total liabilities from total assets. You can find these figures on your balance sheet. Assets often include items such as cash and cash equivalents, property, plant and equipment, and intangibles. And liabilities can include items such as current liabilities and income taxes payable. The formula for calculating business equity is then as follows:
Equity = Total assets − Total liabilities
Calculating business equity
Total assets
Assets are anything that a business owns that could be sold to recoup some of the value. Common business assets include owned property, such as offices or warehouses, cash in the bank, company-owned vehicles, company-owned machinery and equipment, intellectual property, patents and raw materials, says Barber.
Total liabilities
Liabilities are anything that a business owes to an individual, a company or a financial institution, explains Barber. These include loans, credit accounts with suppliers, taxes, salaries, mortgages, dividends and interest. “It is anything that the business must pay before it can make a profit.”
Business equity example
Company A is a tech hardware manufacturer. To calculate their business equity, the first thing they should do is accumulate the value of all of their assets:
- Inventory = £125,000
- Machinery and equipment = £45,000
- Cash and cash equivalencies = £9,500
- Accounts receivable = £55,000
Total assets for Company A = £234,500
Next, Company A should accumulate the total cost of their liabilities:
- Accounts payable = £65,000
- Total debt = £35,000
- Lease obligations = £15,000
- Deferred revenue = £75,000
Total liabilities for Company A = £190,000
Lastly, to calculate its equity, Company A must subtract its liabilities from its assets:
Company A Equity = £234,500 (Total Assets) - £190,000 (Total Liabilities) = £44,500
Company A's business equity is £44,500.
Cost of equity vs. cost of capital
The cost of equity is the return a company pays to its equity investors, to ‘compensate’ them for the risk they have taken in investing their money in your business. It is usually calculated through the Capital Asset Pricing Model (CAPM), that apportions the expected return from the investment, on the basis of the risk of making that investment, Barber explains. It is usually higher than the cost of debt since investors are taking on more risk, he adds.
The cost of capital is how much it costs a business to finance its operations. It considers both the cost of equity, as well as the cost of debt, or the interest payable on company debts, like loans or bonds.
1. The maximum payment period on purchases is 54 calendar days and is obtained only if you spend on the first day of the new statement period and repay the balance in full on the due date. If you'd prefer a Card with no annual fee, rewards or other features, an alternative option is available – the Business Basic Card.
