Equity refers to all the resources invested in a particular business by the owners. It is commonly called owner’s equity or net assets. In other words, the term describes the net investment of stockholders or owners in a business. Equity is governed by the equation that follows: Equity = Assets – Liabilities. The following example gives the real picture of what is equity in a real life situation: If you have a car that is worth $12,000 (an asset) but owe a loan of $8,000 against the car (liability), the car represents $4,000 of equity. In cases where liabilities exceed assets, equity becomes negative. The aim of this article is to give a clear and understandable concept regarding what is equity and everything it entails.
The Concept of Equity
To fully understand the concept of equity, it is important that you first know all the details about the ‘accounting entity assumption’. This assumption states that any given business must be taken as a separate entity from its owners. The business, being a separate entity, will record every financial transaction it does in a separate book to that of the owners.
By applying this assumption, the business is in a position to give detailed and accurate reports regarding its financial position as well as its performance. In addition, the assumption determines the business perspective when it comes to recording financial transactions.
The main aim of starting a business is for the owners to make a profit. On its creation, the business owns nothing and at the same time owes nothing to anyone. At this point, it is just an empty shell. However, from the point of creation going forward, the business will view all financial transactions from its own perspective, which would be different from that of the owners.
The first transaction that the business records are the funds provided by the owners (initial investment) to create the entity. These investment funds provided by the owners to start the business are referred to as owners’ equity. These funds remain in the circulation of business transactions until it ceases to trade. When the owners of the business are shareholders, the initial investment is called shareholders’ equity.
Equity in Other Sectors
What is equity in financial accounting? It entails the net assets of a particular entity. It is usually displayed on the statement of financial position.
What is equity in real estate industry? In this sector, equity is the property’s right that is obtained by deducting the outstanding mortgage from the property’s market value.
Some people may have questions regarding what is equity investment. Technically, equity investment entails buying and subsequently holding stock shares on a stock market with the aim of getting income from capital gains and dividends.
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Advantages and Disadvantages of Equity
Financing a business using equity has its benefits as well as limitations. The following are the main benefits of using equity to finance a business: the business owners do not have to keep up with the high costs of servicing a loan; investors participate in the running of the business to ensure high returns, and it is easier to convince investors to increase their funding as compared to banks.
The following are the main limitations of equity: it is not easy to raise the required finance through equity, as it is demanding; time-consuming; crucial business secrets may land into the wrong hand in the process of wooing investors, and costly and the management may place their efforts on raising the capital, thus forgetting about other important business activities.
Advantages of Equity
1. Total Commitment to the Business
Equity funding is fully committed to the business at hand as well as the intended project. The only way investors will realize their investment is if the business is doing well. Therefore, they will combine efforts to make sure that the business is successful.
2. No Loan Servicing
Loan servicing is the borrower’s obligation to repay the interest and principal of a loan on time. With equity, the investors do not have to keep up with the high costs of servicing bank loans. Instead, they will spend their time on coming up with different ways of improving the operations of the business.
3. Combine Expertise and Skills
Due to the outside investors having a high expectation regarding the success of the business, they will bring in their expertise and skills. The move will improve and grow the knowledge database within the firm. With new ideas brought on by investors, other, more profitable sectors might be considered for expanding the firm’s area of activity.
4. Benefit from Venture Capitalists
Equity financing mostly attracts venture capitalists. This type of investors usually assists the management of the business when it comes to key decision-making and strategy. In addition, they are influential people in society and can help the company win huge government contracts. As government contracts are usually highly profitable, investors will get good returns.
5. Flexible Investors
Most of the time, investors have no problem with increasing their funding as long as the business is viable. Therefore, the company is always in a flexible state and can quickly indulge into any new market that may come up. It is important for a business to be in a position to take any opportunity that comes its way. Nowadays, the market is dynamic and only flexible companies do well. Having investors with the will to increase the funding gives a business a competitive advantage.
Disadvantages of Equity
1. Raising Equity is Not Easy
It is not an easy task to raise equity finance. It is demanding, time-consuming, and costly. Bringing investors to one platform so that they can fund a project may shift the focus of management from important business activities, a situation that may make a company lose many business opportunities.
2. Business Secrets Dilemma
It will not be easy to woo potential investors because they will demand crucial details about the business before making a commitment. Some details are confidential and it will not be easy to disclose to anyone interested in funding the business. Therefore, there will be some delays and this will result in the loss of a number of opportunities.
3. Reduced Business Control
As the owner of the business, you will lose the ultimate control of the firm if you involve investors in raising the capital. The decision-making process will be slow because a number of people will have to be consulted first. Conflict of interests may come into play, further complicating the matter.
4. Reduced Share
Raising funding through equity financing is the same as reducing your share. Investors receive a portion of the business shares according to the capital contribution. In other words, you will have to share the profit realized with all investors. This may reduce your earnings as compared to the earlier case where you were the sole owner. If you are not ready for this, it will be wise if you find other ways of raising the capital.
5. Disagreement Among Investors
A disagreement among investors may lead to an ugly battle in court that may tarnish the image of the company. Such a situation may delay the development of the business. The business may not have an established dispute resolution mechanism, a situation that may affect the smooth running of the business.
The article has answered the question of what is equity in a detailed way. As a potential business owner, I believe equity financing is the best way to fund a business. If a business uses equity as the main source of investment funds, there will be no loan to finance, meaning that the cost of running the business will be low. As a result, the investors will get returns on investment within a short time. They can opt to use the profit in expanding business activities with the aim of increasing the profit. The move will ensure that the business is running more efficiently.