Definition

Equity

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What is Equity?

Equity is the total value of a company which shareholders is entitled to get if all debts of a company are paid off, with its properties liquidated. It is the cost of an enterprise less any liabilities payable by the corporate in the case of acquisition. Furthermore, shareholder equity may be used to represent a company's book value. In a balance sheet, equity is the shareholder’s stake mentioned in the liabilities and Stockholders’ Equity section.

Equity may be used as a form of payment-in-kind. It also represents a company's pro-rata ownership of its shares.

How do you Calculate Equity?

Equity can be calculated by subtracting a company's total liabilities from its total assets. 

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One can find the value of total assets and total liabilities of a company, reported separately, on the consolidated balance sheet of a company. Then, one can calculate shareholder equity by subtracting gross liabilities from total assets.

What are the types of Equity?

Equity is the value assigned to shareholders of a business. A business can sell its equity for acquiring cash which can be used either to start up new or expand the existing operations.

The two types of equity shares sold by the companies are Common Equity and Preferred Equity.

Common Equity: Common stockholders are usually assigned voting rights and holders are entitled to profits through dividends through they rank last for distribution by the company.

Preferred Equity: Less volatile and having lesser potential for profit than common stock, preferred stock usually receives pre-defined dividend.

Why Equity is important?

Equity helps investors determine a firm’s financial health. Equity is used to calculate many financial ratios. However, without the use of other instruments and indicators, shareholder equity itself is not a reliable measure to determine financial health of a company.

Corporations raises money in the form of Equity to buy properties, invest in ventures, and finance operations. A company raises capital through debt including loans or bonds or through equity i.e. by issuing stocks. Equity investments are preferred by investors because they allow them to participate more fully in a company's income and growth.

Shareholders of a company benefit from capital gains as well as from dividends. Shareholders who own stocks will be able to vote on corporate decisions as well as board of director elections. This stock ownership encourages shareholders to remain invested in the company.

After buying a stock in a business, a person becomes its partial owner.

Why should people invest in Equities?

Individuals prefer to invest in equity shares because they have a high rate of return. Despite their potential for high returns, they expose an individual's investment portfolio to some risk. As a result, before deciding to invest in the equity stock, individuals should determine their risk appetite.

What are the advantages of Equity Shares?

Everything has its own benefits, so do equity shares too. Let’s talk about some of them:

  • Provides a cushion against inflation: If a person invests in equity shares, he or she has the opportunity to make a significant profit. The rate of return received is expected to be greater than the rate at which the investor's buying power is reduced due to inflation. As a result, buying stock serves as a buffer against inflation.
  • High returns: Investing in blue-chip equity shares yields a high rate of return in long term. Shareholders have the opportunity to create wealth through dividends and through capital appreciation.
  • Easy to invest: Investing in stocks is easy. In a country, investors can invest in equities through stockbrokers or financial planners. If a person owns a Demat account, he or she can buy stocks in a matter of minutes.
  • Diversified portfolio: Debt securities are favoured by most investors because they provide low-risk investment with less instability. Individuals should branch out their investment portfolio and include debt instruments and equities for higher returns.

What are the disadvantages of Equity Shares

If one gets higher benefits, it is obvious that he/she has to accept some disadvantages too. These include:

  • Performance-related risks: Since equity investments are market-related instruments, they may or may not perform as expected by investors. This is referred to as performance-related risk, and it can impact both individual stocks and stocks across a sector or sectors.
  • High market risk: When compared to other investment options such as debt bonds, investing in equity shares will deliver high returns but also subject investors to high risk. When investing in equity shares, an investor runs the risk of losing all his or her money.
  • Liquidity risk: Due to liquidity risk, investors could be forced to dump their shares at lesser price than their fair market value. If a corporation is unable to satisfy its debt obligations in short term, it faces liquidity risk.
  • Risk of inflation: As a result of increasing inflation, a company's value may be diluted, and its shares may no longer produce future returns.
  • Risks arise due to social and political shifts: Ongoing social and political problems in a country can stifle a company's growth. For example, if a government wishes to encourage indigenous businesses, foreign businesses can be prevented from entering the country. In this case, an investor who has invested in home-grown companies will benefit from improved output of his or her investments.