What do we mean by equity? Here’s the guide to understand the calculation, definition and use of the term. Let’s find out what it is and why it is essential for those who manage a company.
Equity: what is it, what is its definition, how is it calculated and used?
Answering these questions is fundamental to understanding the management of a company, how and if it expresses profits and what the role of shareholders.
In summary, shareholders’ equity refers to the difference between assets and liabilities that make up the balance sheet of a company, but what are the formula and methods that make it possible to calculate it?
When a company or any business is created and becomes operational, the definition of equity coincides with capital (share capital) that the economic entity brings, in principle, is the shareholders.
For the calculation of the net assets it will be appropriate to make some additional clarifications. So let’s see what equity is: definition, calculation and use of the formula.
Equity, what is it? Definition and meaning
The definition of equity is the difference between the assets of a company’s balance sheet and its liabilities.
In practice, when I start a business the meaning of equity is that of the capital I contribute, but in the case of a company that has already started the calculation varies and takes into account provisions, losses and so on.
In asking ourselves what equity is and what its calculation methods are, we are thus trying to understand what is the portion due to shareholders following the deduction of liabilities to third parties from the assets of the company taken into consideration.
In other words, the definition of equity answers the question: what remains of the assets once the liabilities have been removed?
The shareholders’ equity is in practice made up of the internal sources of financing deriving from the subjects that make up the company (shareholders). It is worth remembering that the definition and calculation of equity does not provide information on the value of the corporate security.
It should be noted, then, how the definition of equity differs from that of gross capital (corporate equity) which does not take into consideration only the own means used to finance the company, but also those deriving from the contribution of the capital of credit.
Here, in summary, is what equity is, its definition and the meaning of the term. But what are the methods of calculation of the same?
Equity, what is it? The components
Shareholders’ equity is made up of various components. As far as businesses are concerned, it is made up of share capital, reserves, accumulated losses and profits, as well as minority interests.
- Share capital: by definition it is the calculation of the amount contributed by the shareholders at the time of incorporation of the company and is divided into shares assigned in proportion to the amount paid. "How much do the shareholders put", in summary.
- Reserves: we are talking about corporate profits that are not distributed but stored, both as a form of self-financing and to deal with unforeseen events.
- Profits to be allocated: these are profits that could be either incorporated into reserves or distributed to shareholders.
- Pending losses: referable to both the loss of the last year and to that of previous years awaiting coverage.
Remember that this distinction is not present within individual companies. In light of all these components, what are the methods of calculating the shareholders’ equity?
Equity, what is it? The calculation
Now that we have a clear understanding of what equity is and what its definition, meaning and components are, let’s try to understand how this measure is calculated and why it is so important.
Net equity is calculated using the following general formula:
| share capital + reserves + profits to be allocated - outstanding losses |
Several options can emerge from the calculation of the company’s equity:
- Equity = assets: if it emerges that its value corresponds to that of the assets, it means that the company in question has no debt and is self-financing.
- Assets> liabilities: if instead it emerges that the assets are greater than the liabilities, the calculation of the shareholders’ equity will have a positive result.
- Assets = liabilities: if, on the other hand, the assets and liabilities have the same value, the shareholders’ equity is zero, which means that the company has no self-financing sources but uses those of third parties.
- Liabilities> assets: finally, if the liabilities are greater than the assets, then we speak of negative net equity, that is, a capital deficit.
Example: if a company has assets (fixed assets + current assets) of € 1,391,900 and liabilities (long-term + current) of € 470,000, the calculation of the net assets will be given by the following formula:
| PN = € 1.391.900 - € 470.000 = € 921.900 |
It means that the company’s self-financing means are equal to 921,900 euros.
Difference between shareholders’ equity and share capital
When we ask ourselves what equity is and what its calculation methods are, we often make the mistake of mistaking it for share capital, but the two terms have a very different definition and meaning.
As we saw at the beginning of our discussion, the share capital represents a part of net assets and is the "sum" advanced by those who choose to create a company.
We also reiterate that at the time of incorporation of the company the share capital and shareholders’ equity are equivalent, but with the passage of time they tend to diverge since other elements highlighted as profits, reserves and so on come into play in the calculation.
Here, in short, what is equity, its definition and its calculation methods.
Original article published on Money.it Italy 2022-02-26 13:11:00.
Original title: Patrimonio netto: cos’è? Calcolo, definizione e guida completa
