Equity, often called shareholder equity, is regarded as the sum of money that will be returned to the shareholders of a certain company if all of its assets are liquidated and the whole debt of that company is completely paid off.
Equity is displayed in the balance sheet of a company. It is one of the key indicators that an investor uses to identify a company's financial soundness.
In simpler terms, equity is the total amount of money that a shareholder is eligible to receive if all of a company’s debts are paid off and its assets liquidated. When an individual invests in a company’s equities, he/she becomes its partial owner.
Features of Equity
The characteristics of equities can be tabulated as follows.
Features | Description |
Maturity Period | The equity shares can provide capital to the company, which cannot be regained for as long as the company is functional. Individuals who have invested in the company’s shares can only redeem their capital at the time of the company’s liquidation after all other claims have been fulfilled. |
Shareholders’ Voting Rights | When an individual purchases the equity shares of a company, he/she becomes a real stakeholder in the organization. The power to participate in the company’s meetings is bestowed upon such participants, and they have the right to voice their opinions on a company’s executive decisions. |
Income from Equity Shares | When an individual invests in a company’s shares, he/she acquires the right to claim a company’s income. If a company has insufficient profits, equity shareholders might not earn any gains from their shares, but they also stand a chance of earning higher dividends through capital appreciation. |
Claim on Company’s Asset | Every individual who has invested in a company’s equity shares gains an ownership claim on the company’s assets. |
Limited Liability | Even though shareholders are a company’s real owners, they enjoy the advantage of limited liability. It means that their liabilities are limited only to the value of the shares they have invested in. |
How Shareholder Equity Works?
Investing in equity shares is popular among individuals because they are high-return investment options.
Let us look at how shareholder equity works-
- While investing in a company’s stocks, one can earn profit via capital gains or stock price appreciation.
- Further, investing in a company’s shares also bestows an individual with a right to vote in matters pertaining to the Board of Directors.
Despite their potential to bear high returns, they also have a certain degree of risk. For this reason, it is pertinent for individuals to gauge their risk appetite before deciding to invest in equity stock.
Equity Shares Formula
To calculate a firm's equity, apply the following shareholders equity formula. The calculation derived from the accounting equation is-
Shareholders' Equity = Total Assets - Total Liabilities
This information can be accessed on the balance sheet, where the following four actions must be taken-
- Find the total assets of the company on the balance sheet for the period.
- Locate total liabilities, which should be stated on the balance sheet individually.
- To calculate shareholder equity, subtract total liabilities from total assets.
- It should be noted that total assets will equal the sum of entire liabilities and entire equity.
Shareholder equity is sometimes defined as the difference between a company's share capital and retained earnings less the value of treasury shares.
This strategy, on the other hand, is less common. Though both techniques produce the same exact statistic, total assets and liabilities are more indicative of a company's financial health.
Types of Equity Account
Equities are market-linked investments that do not come with an assurance of bearing fixed returns. Returns on equity thus depend on the underlying asset’s performance.
There are various types of equity accounts that combine to form the total shareholders’ equity. Let's understand here in brief-
Common Stock
Common stock denotes the shareholder’s capital contribution. This account symbolises the shares that permit the shareholders to cast a vote and their remaining claim on the assets of a company.
Preferred Stock
Preferred stock resembles the common stock. It has no voting rights but carries a guaranteed a cumulative dividend.
Contributed Surplus
It represents any amount that is paid over the par value paid by investors for the purchase of stocks that have a par value. It also carries various types of profits and losses that result in the sale of shares. It is also called as Additional Paid-In Capital.
Retained Earnings
It is the part of net income that is not paid as dividends. It is kept for reinvesting in the company or even used for paying off any forthcoming obligations.
Other Comprehensive Income
It is excluded from net income on the income statement as it persists of income that has not been realized as of yet.
Treasury Stock (Contra-Equity Account)
It is a contra-equity account that denotes the amount of common stock that the company has purchased back from investors. It is displayed as a deduction in the books from total equity.
Advantages of Investing in Equity Shares
There are several benefits of equity investment that an individual can enjoy by investing in equity shares. Some of them are enumerated below.
High Returns
Investing in equity shares provides high returns to investors, not just through dividend earnings but also through capital appreciation.
Provides a Cushion Against Inflation
When an individual invests in equity shares, he/she has the potential to earn high returns. The rate of returns earned is often higher than the rate of wearing down of the investor’s purchasing power due to inflation.
Thus, investing in equity shares acts as a hedge against inflation.
Ease of Investment
Investing in shares is simple. Investors can avail of the services of a stockbroker or financial planner to invest through various stock exchanges (NSE, BSE equity) in a country.
If an individual has set up a Demat account, he/she can buy the stocks in a few minutes.
Diversification of Investment Portfolio
Investors mostly choose to stick to debt instruments since they are low-risk investment options owing to lower volatility. However, debt instruments may not always generate high returns, which is why individuals can diversify their investment portfolio by investing in equities for higher returns.
Disadvantages of Investing in Equities
Even though equity investments have their fair share of advantages, they also bear a few disadvantages.
Some of them are as follows-
High Market Risk
Investing in equity shares can yield returns but also exposes investors to high risk as compared to other investment options like debt instruments.
An investor can risk losing his/her entire investment corpus by investing in equity shares.
Performance-related Risks
Equity investments are market-related instruments and, as a result, might not perform according to an investor’s expectations.
This is known as performance-related risk and can affect individual stocks as well as stocks across a sector or sectors.
Risk of Inflation
A company’s worth can get diluted due to rising inflation and subsequently, its shares might not generate potential returns.
Liquidity Risk
Due to liquidity risk, investors might have to sell their shares at a much lower price than their fair market value.
Liquidity risk arises when a company is unable to meet its debt obligations in the short term.
Risks Arising out of Social and Political Changes
On-going social and political issues in a country can hamper the growth of a business.
For example, if a government decides to promote indigenous businesses, it might restrict the entry of foreign businesses into the country. If an investor has invested in home-grown businesses, he/she, in this scenario, will profit from better performance of his/her investments.
Who Should Consider Investing in Equities?
Equities are more suitable for investors who are willing to take a risk with their investments.
Those who are constrained by the limitations in time or experience in the money market can also lean towards equity mutual fund investments for moderate to high returns.
