Definition of equity (finance): the element of a organisations total value which is attributable to its shareholders
Definition of equity (accounting): the book value of assets minus liabilities. The net asset accounting value of the balance sheet.
What does equity mean
In a nutshell, equity represents the ownership interest in a company.
An equity investment is the purchase of shares in a company, and thus the entitlement to a pro-rata share of the company through. This is why stocks and shares are also known as equities.
An equity investment can provide a return in the form of dividend income, and growth in the value of the investment.
How is the word equity used in a sentence?
Here’s a couple of sentences using the word equity in a financial context:
“The company is financed through 60% equity and 40% debt.”
“After the company filed for bankruptcy, bondholders were paid 30p in the pound, whereas equity holders were wiped out”
“The amount of debt on the balance sheet looked heavy, so the directors decided to raise more cash through an equity fundraising round.”
Beyond the definition of equity
Even though shareholders ultimately control a company, there is another group of investors who have a financial interest in a company’s affairs; debtholders.
Debtholders include the owners of corporate bonds or banks which own debentures. Unlike shareholders, they don’t get to vote at the Annual General Meeting, but nevertheless, they have a passive influence on company affairs. This pressure is applied through the implicit threat of bankruptcy, which is a process any debtholder could trigger if a company defaults on their debt.
Therefore, behind every debt & equity capital structure, there is a dynamic whereby the needs of debtholders come first, and those debt has been serviced, the equity holders are entitled to ‘the rest’ of the assets.
The best financial accounting books also point out that equity is presented in a different place on the balance sheet to debt, which reflects this conceptual difference.
This means that equity enjoy the upside in any outperformance of a business.
This is ultimately why equity investments are higher risk, but higher return, compared to debt instruments such as corporate bonds.
How does the definition of equity relate to investing?
If you want to invest in the stock market, or already do, it makes sense to fully understand the concept of equity, and how this relates to your rights as an investor when you buy shares.