Equity is ownership of assets that may have debts or other liabilities attached to them. It is measured for accounting purposes by subtracting liabilities from the value of the assets. It can apply to a single asset, such as a car or house, or an entire business. A business that needs to start up or expand its operations can sell its equity to raise cash that does not have to be repaid on a set schedule.
The fundamental accounting equation requires that the total of liabilities and equity is equal to the total of all assets at the close of each accounting period. To satisfy this requirement, all events that affect total assets and total liabilities unequally must eventually be reported as changes in equity. Businesses summarize their equity in a financial statement known as the balance sheet which shows the total assets, the specific equity balances.
Types of Equity Value:
- Book value: This is the value that accountants determine by preparing financial statements and the balance sheet equation that states: assets = liabilities + equity. The equation can be rearranged to equity = assets – liabilities. The value of a company’s assets is the sum of each current and non-current asset on the balance sheet. The main asset accounts include cash, accounts receivable, inventory, prepaid expenses, fixed assets, property plant and equipment, goodwill, intellectual property, and intangible assets. To fully calculate the value, accountants must track all capital the company has raised and repurchased, as well as its retained earnings, which consist of cumulative net income minus cumulative dividends. The sum of share capital and retained earnings is equal to equity.
- The market value: It is typically expressed as a market value, which may be materially higher or lower than the book value. The reason for this difference is that accounting statements are backward-looking while financial analysts look forward, to the future, to forecast what they believe financial performance will be. If a company is private, then it’s much harder to determine its market value. If the company needs to be formally valued, it will often hire professionals such as investment bankers, accounting firms, or boutique valuation firms to perform a thorough analysis.