Shareholder’s equity is whatever money is left in a company after all assets are sold and debts are paid. The residual value of your business is your equity balance. This balance represents the financial stake you and your business partners have contributed to your company. The figure is useful in financial analysis. Many financial ratios compare a company’s total equity to other aspects of the company to see how well you are using money to make money.
All businesses can raise capital in two ways: debt and equity. Debt financing means you use loans to fund your business. Equity financing means you contribute your own dollars in return for an ownership stake in your company or that you sell shares to others. Businesses with higher shareholders’ equity balances are typically taking on less financial risk.
Shareholders’ equity contains the contributions from all business partners. If you and your business partner each contribute $5,000 to start a company, shareholders equity for your business is $10,000. As you operate your business, whatever net income you earn is added to your equity balance. If you have net income of $7,000 for your first quarter, your shareholders’ equity balance is now $17,000. Note that this is just a basic example to explain shareholders’ equity. It doesn’t take into account any liabilities or expenses incurred in that quarter.
Shareholders’ equity is found on your balance sheet. It is calculated by subtracting total liabilities from total assets. When investors consider buying shares in your company, they may want to know about your shareholders’ equity balance so they can assess which portion of the company’s income they may earn. For instance, a single investor contributing all equity into a company will more likely receive larger (or all) portions of net income than a company with multiple investors.