Which increases and decreases equity

Equity

Equity is that part of a company's capital that represents its net worth. It is calculated from the excess of assets over debts. Self-financing by the company or by leaving the resulting profit in the company creates equity, which is always listed on the balance sheet on the liabilities side. Equity fulfills numerous functions within the company, for example it serves as a basis for liability towards creditors.

In the following lesson you will learn what items the concept of equity comprises and what functions they have within a company. At the bottom you will also find numerous helpful exercises on the topic of equity.

English: equity | equity capital

Why is equity important?

Equity pursues the essential idea of ​​being able to fulfill the company's purpose. It is available to the company for an unlimited period and is not subject to any interest.

What is Equity?

Equity is that part of a company's total capital that is neither debt nor deferred income. It is supplied by the company or the shareholders themselves or generated from profits. Equity is not only created by adding assets, but also includes the company's real estate.

The equity is therefore also subject to entrepreneurial risk and may be reduced by losses incurred.

The calculation of equity is done by determining the excess of assets over debts of a company. If individual balance sheet items are set too high or too low at this point, the reported equity increases or decreases. Only when the company is liquidated will it be possible to determine the exact amount of equity.

Features of equity:

  • unlimited
  • no interest
  • no fixed term
  • no entitlement to repayment by the investor
  • is subordinate to borrowed capital, is the last thing to be paid out to equity investors in the event of the company's liquidation
  • is liable to creditors
  • As owners, equity investors have a high degree of decision-making power and participation rights within the company

In contrast, the debt is made available to the company by third parties. It is usually fixed-term and has a fixed interest rate. The financing does not give the lender any rights of participation or control and no profit-sharing.

Advantages and disadvantages of a high equity ratio

Creating high equity shares has both advantages and disadvantages.

Advantages and disadvantages of equity at a glance:

advantages:
  • The risk of over-indebtedness is reduced
  • No interest payments
  • No repayments
  • Financial independence of the company
  • Allows the company to make higher profits
  • Companies with high equity ratios often get cheaper loans
disadvantage:
  • Equity provider has the right of co-determination
  • Distributions reduce the company's earnings
  • Higher personal risk for the entrepreneur
  • A risk premium may have to be paid out to equity providers
Company X has an extremely high equity ratio. This proportion increases the company's creditworthiness as it has a high level of liquidity. The company therefore receives very good loan terms from the bank.

Functions of Equity

Depending on the form of the company, equity fulfills numerous important functions.

Features of equity at a glance:

  • Founding function: Equity is particularly important when setting up a company. This enables investments to be made and business operations to begin
  • Liability function: The equity capital is liable to the creditors and thus serves as creditor protection
  • Financing function: A high share of equity usually allows the company better conditions when granting a loan
  • Loss absorption function: Losses can be cushioned by equity
  • Risk coverage function: The equity ratio has an impact on how high a company's maximum bearable losses are
  • Measurement function of profit distribution: The dividend rate of the profit to capital providers is based on the amount of equity raised by you
  • Representation function: The share of equity in total capital has a high advertising effect. The higher the equity ratio, the higher the creditworthiness of a company
  • Ruling function: the higher the equity, the greater the say of the investor
Equity provider E brings a high proportion of equity into the company. Equity also establishes ownership of the company to the same extent and enables E a high say.

Types of Equity

The different types of equity are anchored in Section 266 (2) of the German Commercial Code (Handelsgesetzbuch).

Possible balance sheet items of equity:

These balance sheet items just listed are all shown as equity on the liabilities side of the company's balance sheet. Other balance sheet items under liabilities are provisions, liabilities and prepaid expenses.

Practice questions