Equity finance

Equity in finance represents an ownership interest in an asset or entity, defined by the residual value remaining after deducting all associated liabilities. It provides a measure of the holder’s claim over the asset or business and forms a fundamental concept in both accounting and investment analysis. Equity may apply to single assets, business entities, or entire sectors of financial activity, serving as a key indicator of financial health, ownership rights, and potential returns.

Background and Conceptual Foundations

The notion of equity emerged from the English system of equity law, developed in the Late Middle Ages. This legal tradition evolved alongside growing commercial activity, creating a mechanism for adjudicating matters that the common law courts could not adequately address. Common law courts typically determined matters of legal title, whereas equity courts examined contractual interests and emphasised fairness, or equitableness, in the administration of agreements. As a result, the same asset could have two types of ownership: an owner at law, holding legal title, and an owner in equity, holding the beneficial interest. This dual system influenced the terminology later adopted in finance and accounting.
In its modern usage, equity refers to the value interest in an asset after all outstanding obligations have been met. If the liabilities associated with an asset exceed its value, the position is known as a deficit, and the asset is informally described as being underwater or upside down. In government or non-profit contexts, the equivalent concept is termed net position or net assets.

Equity in Single Assets

Any secured asset purchased using borrowed funds generates equity for the buyer. Until the corresponding loan is repaid, legal ownership is partial, with the lender having the right to repossess the asset if the borrower defaults. The equity balance is calculated as the asset’s market value minus the outstanding loan balance. This value may be distinct from the total payments made on the loan, as instalments include interest and the asset’s value may fluctuate.
If a deficit arises, loan terms determine the lender’s rights of recovery. Housing, for example, is commonly financed through non-recourse loans, whereby lenders cannot recover more than the property itself, even if its value has fallen. Conversely, many other assets are financed using full-recourse loans, making the borrower responsible for any deficit.
The equity within single assets can be used to secure additional borrowing. Home equity loans and home equity lines of credit serve as examples, enabling borrowers to leverage accumulated equity while simultaneously increasing their secured liabilities.

Equity in Business Entities

A business entity exhibits a more complex equity structure than an individual asset. Certain liabilities may be secured by specific assets, while others may be underwritten by the business’s entire asset base. In situations of bankruptcy, a business may be compelled to sell assets to satisfy creditors; however, equity reflects the residual interest belonging to the owners once debts have been settled.
Equity in a business represents the ownership stake of shareholders or proprietors. It approximates the value of claims that owners hold over the firm’s net assets, although the market value of this equity may differ significantly from its accounting value due to commercial prospects, available credit, and investor sentiment.

Accounting Treatment

Equity is central to financial accounting and forms one of the three primary components of the accounting equation:
Assets = Liabilities + Equity
Equity is determined by subtracting total liabilities from total assets. To comply with accounting standards, all events affecting assets or liabilities in unequal measure must eventually be reflected as changes in equity.
On a balance sheet, also known as the statement of financial position or statement of net position, equity may comprise several specific accounts:

• Share capital or capital stock – contributions from investors.
• Capital surplus or additional paid-in capital – amounts received above the nominal value of shares.
• Treasury stock – a contra-equity account reflecting the cost of repurchased shares.
• Retained earnings or accumulated deficit – cumulative net income or losses not distributed as dividends.
• Reserves – specialised accounts used for reconciling particular financial movements, particularly in the United Kingdom.

Another important statement, the statement of changes in equity, details movements in these components over the accounting period. Several events influence business equity, including:

• Capital investments, which increase contributed capital.
• Accumulated results, whereby profits add to retained earnings and losses reduce them.
• Unrealised gains or losses, such as changes in the fair value of investments or foreign exchange holdings.
• Dividend payments, reducing retained earnings.
• Stock repurchases, increasing treasury stock.
• Liquidation, in which any positive residual equity is distributed to owners.

Equity Investing

Equity investing involves the purchase of shares in companies with the expectation of earning dividends or achieving capital gains upon resale. Equity investors generally obtain voting rights proportionate to their shareholding, allowing them to participate in the selection of the board of directors and, in some cases, influence managerial decisions.
The value of a company’s equity in the stock market does not necessarily correspond to its book value. Market pricing reflects broader factors, including anticipated profitability, sectoral trends, risk exposure, liquidity conditions, and investor expectations.
One well-known valuation approach centres on intrinsic value, which estimates whether a stock is undervalued by comparing its market price with the present value of future cash flows attributable to shareholders. Notable proponents include Benjamin Graham, Philip Fisher, and Warren Buffett.
In contrast, structural models such as the Merton model treat equity as a call option on the firm’s overall enterprise value. Here, the liabilities function as the strike price. Under limited liability, shareholders may allow a firm to default when its value falls below its debt obligations, akin to not exercising an out-of-the-money option. When firm value exceeds debt, the option is considered in the money, and shareholders retain control.
In this view, bankruptcy becomes a probabilistic event, with equity value dropping to zero if default occurs. This conceptual framework has significantly influenced modern credit risk modelling.

Legal Foundations of Equity Ownership

At incorporation, a firm’s founders or early investors contribute capital, receiving shares representing their ownership interest. This capital remains with the firm throughout its operations unless lawfully distributed. If a business enters liquidation, equity holders serve as residual claimants, receiving any remaining value after all creditors have been paid. Should equity be negative, owners receive nothing and creditors bear the loss.
The principle of limited liability protects shareholders from being personally liable for the company’s debts, provided no fraud or wrongful trading has occurred. Some companies issue multiple classes of shares, each with distinct voting rights or liquidation preferences, adding complexity to both accounting and valuation.

Significance and Applications

Equity plays a central role across finance, investment, and accounting due to its multiple functions:

• It measures an economic stakeholder’s residual claim on assets.
• It acts as a mechanism for raising capital without incurring mandatory repayment obligations.
• It provides a basis for assessing corporate performance through retained earnings and equity changes.
• It underpins investment strategies and valuation models.
• It determines rights, responsibilities, and risks for asset and business owners.