Answers what is business equity, why it matters and how to increase it, and explains how private equity works in the business world – with examples for both.
What is business equity?
Business equity definition:
So what is equity in business? Put simply, equity is the total of a company’s funds from which all debts and liabilities have been deducted.
Business equity meaning:
Equity means the funds that are available to a company if all debts and liabilities are deducted and, on the other hand, the profit generated was left in the company. In addition to financial reserves and – depending on the legal form – share or share capital, equity can also include items of owned premises, plant and equipment. This means that all machines or other systems also flow into equity.
Debt to equity ratio formula
Equity and debt together form the total capital. The equity ratio describes the share of equity in total capital (balance sheet total), expressed as a percentage (%).
The formula for calculating the debt equity ratio is: Equity ratio = equity / total capital.
The equity ratio is one of the indicators for the risk and creditworthiness of a company: a high equity ratio (in reverse: a low level of debt) reduces the risk of insolvency from over-indebtedness and insolvency – but may also reduce the return on equity. The equity ratio can be increased through various measures such as capital release, capital increases or retained earnings.
The more equity a company has, the better. Often the amount compared to outside capital is used as a guide to how serious entrepreneurs really are with their company. The so-called equity ratio is determined for this purpose. It can be calculated by dividing the value of the equity by the value of the total capital. In general, one can say that the share of equity is not less than 20 percent – it should be even higher.
A higher share of equity leads to more trust on the part of investors and banks because possible losses can be absorbed more easily. In addition, a good equity ratio also means security and independence for entrepreneurs.
Business equity example
The founders of a company only have a 15 percent share of equity in the total capital of the start-up . But since they know that it should be up at least 20 percent, they decide, in the context of equity financing to increase their equity. This is done by having another shareholder join the company with the required amount of equity, thus increasing the equity ratio.
Example: Calculating the equity ratio
One company has equity of $300,000 in its balance sheet as of December 31, 2020. The total capital or the balance sheet total is $1 million.
|Current assets||Borrowed capital|
|Claims from L + L||120,000||Liabilities from L + L||200,000|
|Cash register, bank||80,000|
Calculation of the equity ratio
The equity ratio is thus: $300,000 / $1,000,000 = 0.3 = 30%.
Equity ratio problems
Suppose the company manages to agree twice as long payment terms with its suppliers; this would increase the delivery liabilities by $200,000 to $400,000 and we assume that the bank balance is accordingly $200,000 higher.
The balance would then look like this:
|Current assets||Borrowed capital|
|Claims from L + L||120,000||Liabilities from L + L||400,000|
|Cash register, bank||280,000|
This actually positive development (longer payment terms, thereby higher liquidity) has a negative effect on the equity ratio in the example: Equity ratio = $300,000 / $1,200,000 = 25%.
If the increased liquidity is used, for example, to reduce bank loans by $200,000, the equity ratio would at least remain the same.
For this reason, some companies or analysts do not use total capital in the denominator of the formula, but the sum of equity and long-term, interest-bearing debt (while short-term liabilities are excluded).
How to increase business equity
Equity can be increased in two different ways. It can be made available to the company by either increasing the equity contributions or by bringing new shareholders on board and these act as equity providers. This form of equity increase is also known as equity or deposit financing through equity capital. Another possibility is for the company to finance itself from within. In this case, the equity is increased by accumulating part of the profit and not distributing it to the shareholders. The equity gained is then booked under the point of retained earnings or as hidden reserve.
Disadvantages of a high equity ratio
However, a high equity ratio has a negative effect on the return on equity – the leverage effect.
Increase in the equity ratio
The equity ratio can be improved by taking measures on the asset side and the liability side of the balance sheet:
- Asset side
- Capital release measures
- Liabilities side
- Capital increases (external financing)
- Retention of profits (internal financing)
The equity ratio can be increased while the balance sheet total remains the same by replacing outside capital with equity capital or the company lowers the balance sheet total by reducing its assets, e.g. by reducing inventories (inventory optimization, just-in-time), outstanding receivables (shorter customer payment targets, Dunning, factoring) or fixed assets (e.g. through leasing).
What is private equity?
Private equity is equity that is provided by private or institutional investors.
The term private equity can be translated as ‘over-the-counter equity’, which means that it is a form of equity capital that cannot be traded on the stock exchange. Investors are often private equity firms that specialize in precisely this type of investment.
The investor acquires company shares for a limited period of time through his participation and can thus generate financial returns. In order to make the return as attractive as possible, private equity companies select companies that can demonstrate a good risk-return ratio and thus have a high and stable cash flow.
Private equity and venture capital
Participated a private equity firm with equity at a young innovative companies, it is also called risk capital (venture capital), since such an investment is characterized by a higher risk-return. In this case, the investor is known as a venture capital company. The risk of investing is higher because most of the companies involved have just been founded and are still at the beginning of the industry life cycle. Therefore, the income that the venture capital company can generate cannot yet be estimated. Depending on the situation, you may experience a total loss or an above-average return. In addition to capital, the startup.
With this type of participation, business know-how is often provided by the investor in order to make the participation as risk-free as possible. The investor helps, for example, in establishing business contacts and supports the young entrepreneurs in business decisions. In return, the venture capital company is granted certain rights of say that go beyond the usual rights in the context of a participation.
Private equity example
Harry and Paul have a brilliant business idea. The concept and the complete business plan are already in place, but they don’t have the money to implement their idea. Since their concept is as risky as it is ingenious, the bank only shook their heads instead of money. Fortunately, a short time later, a private equity company showed interest in participating, so that Harry and Paul were able to implement their business idea as young entrepreneurs with support by their side.