Equity: definitions and functioning of the different forms of equity
If there is one term that is essential to know in the management of a company, it is undoubtedly equity. Translated into English as equity, equity is injected by partners or shareholders in order to finance a company. In this article, you will discover the difference between public equity and private equity, the different forms of equity, its main advantages and disadvantages and how to calculate its return.
Equity Defined
Equity means the financial resources of a company. Also called own funds, it is defined by the company’s assets minus its debt (liabilities).
Equity is established when a company is founded and throughout the period of activity from the revenue it generates.
Equity is calculated in the company's balance sheet and may be increased by shareholders when they decide to retain profits rather than distribute them as dividends.
Calculating equity is one of the principal methods for assessing the value of a company.
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Equity and Net Assets
Sometimes, equity is referred to as net assets. For example, this is the case of a cooperative or a mutual insurance company which do not include share capital in their by-laws. Now, the value of their assets often exceeds their liabilities, and this is referred to as net assets.
The equity of a company can include:
● Tangible assets ("physical" assets) such as land, shares, bonds, furniture, equipment, buildings, receivables, cash, etc.
● Intangible assets such as copyright, patents, trademarks, the customer portfolio, goodwill, the company’s reputation, etc.
For information, a company’s liabilities include, for example, accounts payable, loans, interest, taxes, unearned revenue, different guaranties or wages and salaries.
What is Equity Used For?
Like the gearing and discounted cash flow, equity is a good indicator of the financial structure and health of a business.
In addition to limiting the risks of bankruptcy), having a level of equity superior to that of your debt gives your current and future creditors an additional guarantee. It can therefore be interpreted as a guarantee of financial security.
As a stable resource of a company, equity is by definition a permanent source of funds, i.e. it is always available to the manager. In this respect, it guarantees solvency and attests to the company’s capacity to honour debt incurred. The higher the equity, the lower the risk of bankruptcy. On the other hand, a company with negative equity is a company that owes more than it owns.
There is also a second advantage, namely the ability to demonstrate that the company is responsible and develop a brand image among target audiences such as:
● Customers and prospects, to facilitate exchanges in the context of contracts;
● Suppliers, which will be more likely to grant advantageous payment terms;
● Banks and creditors, which will be reassured that their loans will be repaid on time.
Finally, the equity equation is greatly appreciated by investors. When raising capital, a company can issue debt either through a loan, bonds or through equity by selling shares.
At this point, an investor can calculate the return on equity to decide whether it should invest in the company or put its money in a bank, for example. Thus, equity represents the value of an investor's stake in a company, equivalent to the proportion of shares it holds.
What Makes Equity?
At the accounting level, equity is broken down into several elements:
● Share capital,
● Reserves,
● Retained earnings,
● Share and contribution premiums,
● Financial period earnings,
● Investment grants,
● Regulated provisions.
Share Capital
Share capital is defined as the sum of money deposited when a company is founded or during a capital increase. Shareholders are usually the providers of funds. Depending on the legal status of a company, share capital is composed of securities (shares or corporate rights). It includes three types of contributions:
● Contributions in cash, i.e. money contributions granted by providers of funds. In exchange, they receive securities in proportion to their contribution and then obtain dividends and voting rights.
● Contributions in kind, i.e. contributions of physical assets (buildings, machinery, equipment, etc.) and intangible assets (patents, trademarks, etc.).
● Contributions of skills, i.e. contributions of knowledge or technical expertise.
Reserves
As an integral part of equity, reserves are prior profits that have not been distributed. As their name suggests, reserves are set aside to cope with any operating or cash flow problems. They therefore act as a financial safety net for a company.
There are three types of reserves:
● Legal reserves, equivalent to at least 5% of profit and a maximum of 10% of the share capital.
● Statutory reserves, which allow partners and shareholders to freely define the portion allocated each year.
● Discretionary reserves, which an ordinary general meeting can decide to create or not.
Retained Earnings
Also considered equity, retained earnings means the portion of company profits that are neither distributed nor posted to reserves. They are used to anticipate a decline in or even a loss of business over the next financial period. This means shareholders can postpone their decision on the appropriation of profits to a general meeting held at a later date.
Share and Contribution Premiums
These premiums correspond to the surplus of the share price of new shares over the nominal value of the shares or corporate rights granted to the contributor in mergers and acquisitions. The term share premium is used for joint stock companies and contribution premium for other types of companies.
Financial Period Earnings
To obtain the earnings of a financial period, the company's expenses are deducted from its revenue. The earnings of a financial period consist of:
● Operating income, generated by the company’s activity. Operating expenses are subtracted from the value of operating income.
● Financial income, corresponding to the financial situation of the company in relation to its financing strategy. The principle is the same, simply subtract financial expenses from the financial income.
● Exceptional, or non-recurring income, calculated from the exceptional income and expense items recognised by the company. The non-recurring expenses are deducted from the non-recurring income.
Investment Grants
In France, a number of public or private institutions give investment grants to companies, sometimes even without any obligation to repay. This financial support gives companies a helping hand with making their investments. Investment grants may help to buy new equipment, take on new hires or expand the business internationally, for example.
Regulated Provisions
Introduced by tax provisions, regulated provisions are a form of tax-free cash flow support. They include:
● The regulated provision for a price increase
● The regulated provision for exceptional depreciation
● The regulated provision for start-up loans and former employee loans.
How to Calculate Equity
As a general rule, equity is calculated when preparing the balance sheet. To obtain the amount, the equity components (see above) are added up and then the company’s debt is subtracted from the amount.
The formula is therefore as follows:
Equity = (share capital + reserves + retained earnings + share and contribution premiums + financial period earnings + grants + regulated provisions) - debt
Below is a more simplified version of the equity formula:
Equity = company assets – company liabilities
Now, let's use an example to illustrate this equity calculation.
In 2020, company X had assets worth €850,000, with €400,000 in cars, €400,000 in machinery and €50,000 in office furniture. In this context, company X had incurred a debt of €500,000.
In 2029, company X therefore had equity of: 850,000 – 500,000 = €350,000. Its equity therefore amounted to €350,000.
It may also be appropriate to calculate the average equity of a company, as equity can fluctuate from year to year. In order to calculate average equity, first decide which equity years you wish to include in the calculation. Add them up and then divide by the number of years.
If we reuse the example of company X which had equity of €350,000 in 2020, €400,000 in 2019, €210,000 in 2018 and €60,000 in 2017, the formula is as follows: (350,000 + 210,000 + 400,000 + 60,000) / 4 = €255,000 of average equity over the past four financial years.
Understanding Equity
If you are a business owner, it is important to regularly assess the financial health of your company. A quick assessment of your equity will give you an initial estimate of its value.
To put it simply, the greater the equity, the greater the value of the company. Conversely, the lower the equity or even negative equity (see below), the lower the value of the company.
Equity and Company Valuation
In a company valuation, equity is an essential item to consider as it defines the company’s net value. This is useful in two scenarios:
● If you wish to invest in a company
● If you wish to liquidate your company
To invest in a company listed on the stock market, you can simply look at the share price of the company and its market capitalisation. However, for companies that are not listed, other methods must be used to estimate their value. In this case, the book value of a company can be estimated through the equity equation. In exchange for the sale of shares, a public or private investor can contribute funds in order to contribute to the company's growth.
In the case of liquidation, equity corresponds to the sum of money that shareholders should, in theory, receive. Note that: it is important to rely on other calculation methods (such as gearing ratios, discounted cashflow, etc.) to correctly assess the value of a company.
Equity and Debt
Equity is directly tied to a company’s debt. In order to measure the degree of risk exposure, financial analysts assess the debt to equity ratio (also called the gearing ratio). The smaller the share of equity in a company's resources, the more risk it is exposed to. This means the company has made extensive use of debt. Over time, a debt to equity ratio can jeopardise the future of a company.
The debt to equity ratio formula: Debt to equity = total debt / equity
There are several types of financial debt:
● Bonded debt, granted when bonds are issued
● Loans from financial institutions
● State advances
● Debts on equity investments.
Decrease in Equity: What to Do
While analysing your cash flow, you realise that your equity has decreased significantly. But there is no need to panic; there are several solutions to deal with this type of situation.
What to do if equity is lower than half the amount of share capital
Throughout a company’s life cycle, there can be times when the value of equity falls below half the amount of its share capital. In France, this alert threshold legally requires the corporate officer to notify the owners, i.e. the shareholders. This situation can arise faster than expected.
In our previous example of company X, its share capital amounts to €180,000 and its equity to €350,000. An operating loss of €200,000 due to a financial or health crisis would lead to a revaluation of its equity at €150,000 (350,000 – 200,000 = 150,000). Company X would then be required to follow a specific procedure. The manager must then convene an extraordinary general meeting of shareholders. It has the option between:
● Deciding on the early dissolution of the company;
● Deciding to continue the company's business while rebuilding its equity.
The decision taken must be published in the bulletin of legal notices and steps must be carried out at the court registry. A note will also be included on the company’s official registration document.
Note that this mandatory procedure applies in France to limited liability companies as well as simplified joint stock companies.
Can Equity be Negative?
Yes, this scenario is entirely possible. It happens when a company has more liabilities than assets. The difference between the assets and liabilities is therefore negative. Negative equity indicates that a company’s assets are financed more by loans than by funds generated by the company’s business. In theory (only), this means that it technically no longer has any value, or has a negative value.
Logically, if equity is negative, this means it is necessarily below half the amount of share capital. The procedure indicated in the previous paragraph must then be followed. At the same time, shareholders are required to decide whether or not to dissolve the company within four months of recognising the loss.
Note that: having negative equity does not mean that a company is bankrupt. In the case of a long term loan, it is likely that the company will no longer be able to repay the bank on the due dates. If the company has taken out a short-term loan, the manager will have to prevent the creditor from declaring the debt in default, as a creditor is entitled to file for bankruptcy with the competent court.
You can therefore see how important it is to regularly monitor your company's cash flow using management tools such as Agicap.
How to Rebuild Equity
In the event of a significant drop in a company’s equity, the best solution remains the same: increase its value! To rebuild equity and secure the company's future, it is advisable to bring in cash from shareholders through a capital increase or by recovering receivables by increasing sales (by liquidating stocks, for example). It is also possible to retain profits without distributing them to shareholders. Shareholders can also trigger the procedure for waiving or incorporate a shareholder’s current account into the capital.
Important: the procedure requires the minimum amount of equity to be recovered within two years. Otherwise, the company will have to reduce its share capital.
Equity and Consolidated Accounts
If a group owns at least two separate companies, how is its total equity value calculated? The principle of consolidated accounts, namely combining the entire financial situation as if it were a single entity, should then be applied. To do this, the share of the equity of the subsidiaries corresponding to the shares held by the "consolidating" company must be deducted from the book value.
When preparing consolidated accounts, certain changes must be made in the calculation:
● Investment grants and regulated provisions are directly integrated into reserves on a tax-free basis. Any related tax credits or liabilities are recognised as deferred taxes.
● Revaluation differences and equity method differences are eliminated. The valuation of tangible and financial assets then follows the specific rules for consolidated accounts (IAS/IFRS international standards or domestic standards).
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