Equity

How is it calculated?

Equity = Assets - Liabilities

Goal of the Calculation

Equity is the difference between the sum total of all assets owned by the business less the sum total of all liabilities of the business.  A business’s assets are financed one of two ways, with debt or with equity.  I like to think of equity as “owning” versus debt as “renting.”  Sure the business owns all the assets on its balance sheet, but they other side of the balance sheet shows how they paid for it.  Did they just “rent” those assets, or do they truly “own” those assets.  The Equity figure on a balance sheet shows how much of their assets they truly own.   

Why does it matter

Equity represents the amount of risk present for the borrower (and his creditors).  The higher the amount of equity present, the larger of economic storm the business can sustain.  As the proportion of equity increases, the risk in the business decreases.

Rules of Thumb

Higher is Better because it causes a business to be able to weather a larger economic storm than a business with lower equity, but if a business has too much equity, it no longer has a reason to borrow money.  

What changes in the ratio could mean:

Some example reasons why Equity can change:

1. Profit or Loss on the Income Statement
2. If a market value balance sheet, changes in Market value of assets
3. Contributions/Distributions
4.  

Other Relevant Terms

• Capital
• Balance Sheet
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