As a business owner, you’ve probably heard about equity and may have an idea of what it means. Here’s a reminder: the term ‘equity’ refers to the cash value of an asset (valuable item) your business owns after you’ve paid financial obligations like tax and debts. But what actually counts as equity in accounting?
This guide will cover:
- What equity means in accounting terms
What does equity mean in accounting terms?
Equity has two primary meanings in finance and accounting. First, equity can refer to the amount of money you have left after subtracting the sum of your liabilities (money you have to pay) from your assets. This is also called the ‘owner’s equity’ since it’s the value you have left as the owner of the business.
The other meaning equity has in accounting refers to its market value, meaning how much it’s worth to investors. This equity value is based on current share prices (how much a share of your company costs) or determined by the investors themselves. Also called ‘shareholders’ equity’ or ‘net worth’, it represents the total value of all your company’s assets after you’ve paid your liabilities.
What counts as equity in accounting?
To understand how equity works in accounting, you need to know which assets count as equity. In simple terms, a company’s equity can include tangible assets (physical items) and intangible assets (items with value but no physical form).
Here are some examples of tangible and intangible assets:
- Accounts receivable – this refers to money that’s owed to you, such as customers’ unpaid invoices
- Building(s) – could be an office, workshop, restaurant premises, a salon, a warehouse, and so on.
- Cash – actual money in your business account
- Equipment – like a laptop, bakery oven, tools, etc.
- Furniture – for example, a desk and desk chair
- Inventory – goods and materials that you have for sales purposes
- Brand recognition – your company name in itself could be a valuable asset (like Nike, Amazon, or Coca Cola)
- Copyrights – your exclusive legal right to your brand name or inventions
- Patents – legal ownership of your invention
- Trademarks – a symbol, word, or words legally registered or established to represent your company
The assets of a company are offset by its liabilities, such as
- Accounts payable – money you owe to other people or businesses, like unpaid supplier invoices
- Interest – a percentage added to loans, mortgages and other debts
- Loans and mortgages – like a car loan or a mortgage for your work premises
- Taxes – like Corporation Tax (limited companies), income tax (sole traders), or VAT (companies making more than £85,000 in a year)
You or your accountant will take all these puzzle pieces to track your company’s value. You must also include any share capital (parts of your business owned by shareholders) and retained earnings (your take-home cash) in the equation.
Why is equity important in business?
As a business owner, you can usually only afford to invest a certain amount of your own money in your business. For small businesses and sole traders, knowing your equity enables you to determine where you can do better to help grow your business.
A common option for sole traders is applying for a business equity loan to borrow money, using their current business assets as collateral. Most banks can offer a loan of around 80% of your business’ equity value. This form of funding can be a great way to get the money you need to grow your business.
Sole traders can also choose to turn their private businesses into limited companies. This is called ‘incorporation’, and means selling shares in your business to investors. These investors then become shareholders and own a part of your business. This is often referred to as ‘equity financing’.
How does equity financing work?
Equity financing can be risky and rewarding for investors and business owners alike. On the one hand, the investor takes a risk since the company doesn’t pay back the investment. Instead, they get a share of the profits (called dividends).
But shareholders don’t own the business in the sense that you do, meaning they don’t make any business decisions. They just sit back and, hopefully, watch their investment grow. If your business’ equity grows in value, so do the investors’ shares.
Bear in mind that investors may sell their shares back and cash out at any point. This is what makes it risky for you as the business owner.
Where is equity recorded in accounting?
When filling in your accounting documents, you record equity on your balance sheet, which records the balance of all your ingoing and outgoing cash. Your equity should be clearly displayed at the bottom of the statement, under either “Shareholders’ equity” or “Owner’s equity”.
Ideally, you want this number to be positive (above 0), which means your business is profitable (earns more money than it spends). If your equity number is negative, it means your liabilities outweigh your assets. In other words, your business spends more than it makes.
Consistently generating negative equity means you need to rethink your business model to lower your expenses and make more sales.
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