What is Equity
Equity (Definition)
Equity refers to the ownership interest that an individual or entity has in an asset, usually calculated as the value of the asset minus any outstanding debts or liabilities. It can also refer to the value of the portion of a company's assets that belong to the owners, known as shareholders' equity, which includes retained earnings and contributions from stockholders. In finance and accounting, it represents the residual value of assets after deducting liabilities. In the context of investments, equity generally refers to stocks or shares in a company or fund.
Here is a simple example of equity:
John is interested in buying a property worth $500,000, but he only has $100,000 saved up for a down payment. He applies for a mortgage loan and is approved for a loan of $400,000. This means that he has an equity of $100,000 in the property.
Equity can also be calculated as the difference between the current market value of the property and the remaining mortgage amount. For example, if the property's value increases to $550,000 and John still has $350,000 left on his mortgage, his equity in the property would be $200,000 ($550,000 - $350,000).
Alternatively, let's say John decides to start a small business with a partner. They decide to invest $50,000 each in the business, meaning they have a total equity of $100,000 in the company. As the business grows and generates profits, retained earnings (profits not distributed to shareholders) will increase the company's equity. Likewise, if the business incurs losses, retained losses will reduce the company's equity.
Here's another example of equity:
Sandy, Bob, and Jane decide to start a small software development company and each contribute $100,000 to get the business off the ground. This means that the company has a total equity of $300,000.
Over the next year, the company generates $200,000 in profits, which they decide to retain in the business instead of paying dividends to the shareholders. This means that the retained earnings will add to the company's equity over time.
At the end of the year, the company has $500,000 in assets and $200,000 in liabilities, leaving $300,000 in equity. Each shareholder's share of equity would be $100,000, which represents their ownership interest in the company.
As the company continues to grow and generate profits, the shareholders' equity will increase if the retained earnings are reinvested in the company. However, if the company incurs losses, the equity will decrease.
