Equity
Definition of Equity
Equity is the capital provided by a company’s owners. It represents the financial foundation of the company and serves as security for creditors. Equity is tied up in the company indefinitely; there is no obligation to repay it. As a balance sheet item, equity is defined in Section 266(III) of the German Commercial Code (HGB) for corporations. It can take the form of subscribed capital, reserves, and retained earnings. On a balance sheet, equity, together with debt, constitutes liabilities, which are offset against assets.
Advantages and Disadvantages of Equity
A high equity ratio can be advantageous for a company, as it strengthens the liability base and improves the company’s creditworthiness—for example, from a bank’s perspective. This can enable the company to raise more debt or to do so on more favorable terms. Equity can also help strengthen the confidence of investors, customers, and suppliers. An important metric in this context is the equity ratio, which measures equity as a percentage of total capital.
Functions of Equity in a Company
Equity thus fulfills various important functions within a company:
Depending on the chosen legal form, it is not possible to establish a corporation without providing a minimum amount of equity.
Equity capital defines management rights and profit distribution. The basis for calculation is typically the equity shares held by the individual shareholders of the corporation.
As part of so-called equity financing, new financial resources can be made available to a company in the form of equity.
Equity capital assumes an important liability function for potential losses, can thus secure a company’s survival in crisis situations, and enhances its creditworthiness.
Cost of Equity
An equity investor expects appropriate compensation in the form of dividends and increases in the company’s value in exchange for providing equity capital and assuming business risks. Hidden reserves or hidden losses within the company mean that the effective value of the equity can only be determined upon sale or liquidation.