At the start of a business, owners put some funding into the business to finance operations. This creates a liability on the business in the shape of capital as the business is a separate entity from its owners. Businesses can be considered, for accounting purposes, sums of liabilities and assets; this is the accounting equation. After liabilities have been accounted for the positive remainder is deemed the owner's interest in the business.
This definition is helpful in understanding the liquidation process in case of bankruptcy. At first, all the secured creditors are paid against proceeds from assets. Afterward, a series of creditors, ranked in priority sequence, have the next claim/right on the residual proceeds. Ownership equity is the last or residual claim against assets, paid only after all other creditors are paid. In such cases where even creditors could not get enough money to pay their bills, nothing is left over to reimburse owners' equity. Thus owners' equity is reduced to zero. Ownership equity is also known as risk capital or liable capital.
Equity investments
An equity investment generally refers to the buying and holding of shares of stock on a stock market by individuals and firms in anticipation of income from dividends and capital gains, as the value of the stock rises. Typically equity holders receive voting rights, meaning that they can vote on candidates for the board of directors (shown on a proxy statement received by the investor) as well as certain major transactions, and residual rights, meaning that they share the company's profits, as well as recover some of the company's assets in the event that it folds, although they generally have the lowest priority in recovering their investment. It may also refer to the acquisition of equity (ownership) participation in a private (unlisted) company or a startup company. When the investment is in infant companies, it is referred to as venture capital investing and is generally regarded as a higher risk than investment in listed going-concern situations.The equities held by private individuals are often held as mutual funds or as other forms of collective investment scheme, many of which have quoted prices that are listed in financial newspapers or magazines; the mutual funds are typically managed by prominent fund management firms, such as Schroders, Fidelity Investments or The Vanguard Group. Such holdings allow individual investors to obtain the diversification of the fund(s) and to obtain the skill of the professional fund managers in charge of the fund(s). An alternative, which is usually employed by large private investors and pension funds, is to hold shares directly; in the institutional environment many clients who own portfolios have what are called segregated funds, as opposed to or in addition to the pooled mutual fund alternatives.
A calculation can be made to assess whether an equity is over or underpriced, compared with a long-term government bond. This is called the Yield Gap or Yield Ratio. It is the ratio of the dividend yield of an equity and that of the long-term bond.
Accounting
In financial accounting, equity capital is the owners' interest on the assets of the enterprise after deducting all its liabilities. It appears on the balance sheet / statement of financial position, one of the four primary financial statements.Ownership equity includes both tangible and intangible items (such as brand names and reputation / goodwill).
Accounts listed under ownership equity include (example):
- Share capital (common stock)
- Preferred stock
- Capital surplus
- Retained earnings
- Treasury stock
- Stock options
- Reserve
Book value
The book value of equity will change in the case of the following events:- Changes in the firm's assets relative to its liabilities. For example, a profitable firm receives more cash for its products than the cost at which it produced these goods, and so in the act of making a profit, it is increasing its assets.
- Depreciation - Equity will decrease, for example, when machinery depreciates, which is registered as a decline in the value of the asset, and on the liabilities side of the firm's balance sheet as a decrease in shareholders' equity.
- Issue of new equity in which the firm obtains new capital increases the total shareholders' equity.
- Share repurchases, in which a firm gives back money to its investors, reducing on the asset side its financial assets, and on the liability side the shareholders' equity. For practical purposes (except for its tax consequences), share repurchasing is similar to a dividend payment, as both consist of the firm giving money back to investors. Rather than giving money to all shareholders immediately in the form of a dividend payment, a share repurchase reduces the number of shares (increases the size of each share) in future income and distributions.
- Dividends paid out to preferred stock owners are considered an expense to be subtracted from net income[citation needed](from the point of view of the common share owners).
- Other reasons - Assets and liabilities can change without any effect being measured in the Income Statement under certain circumstances; for example, changes in accounting rules may be applied retroactively. Sometimes assets bought and held in other countries get translated back into the reporting currency at different exchange rates, resulting in a changed value.
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