What is equity, and why does it matter?

If you own a business, it’s essential to know exactly how much money you have. Unfortunately, it’s not as simple as checking your bank account since you’ll probably have equity tied up in various places.

To get an accurate picture of your business’s value, it’s crucial to understand what equity is and how much of it you have.

Learn everything you need to know about equity in the business context, including:

●        What is equity?

●        Why does equity matter?

●        How to calculate the equity in your business

●        How to manage your equity more effectively with Countingup

In the simplest terms, equity is the cash value of a valuable item you own after paying off any liabilities like tax or interest.

As an example, if you own a house worth £100,000 and still owe £30,000 in mortgage payments, you own £70,000 worth of equity in your house. 

You can think of your small business’s equity in the same way: the value of all your business assets, minus the money you owe on them. This remaining value is the equity you own in your business (often called ‘Owner’s Equity’).

Normally, you can only afford to invest a certain amount of your own money in your business. For small businesses and sole traders, knowing your equity is an important part of continued growth.

A common option for sole traders, you can apply for a business equity loan to borrow money, using your current business assets as collateral.

Most banks can offer a loan of around 80% of the value of your business’ equity. This can be a great way to get the money you need to grow your business.

Small businesses and sole traders also have the option of turning their private business into a limited company. This is called ‘incorporation’.

Incorporating a business means you sell shares in your business to investors, who then become shareholders. These investors own a part of your business. This is often referred to as equity financing.

Shareholders don’t own the business in the sense that you do – they don’t make any business decisions. They just sit back and, hopefully, watch their investment grow. If the equity of your business continues to grow, the investors’ original shares become more valuable. They may sell their shares back and cash out at any point.

This is where equity valuation becomes important.

If you’re going to sell shares in your company, you’ll need to know how much a share is worth, which you can do by calculating your business equity.

For small businesses to take the next big step in expansion, it’s vital to know your equity. But how do you determine your business’s equity?

We mentioned this briefly before; it’s about calculating what you owe (liabilities) against what you own (assets).

Assets – Liabilities = Equity

Below, we’ve included some examples of assets and liabilities to help you get started.

Anything that has been paid for can be considered an asset. This is an important distinction because your company might hold valuable property that has no tangible cash value.

This might include intellectual property, your brand name or a great customer service method. While these things have value, it’s difficult to put this into hard figures so they won’t generally come into the equity equation.

A good rule of thumb to follow is – if it doesn’t appear on your expense report, it doesn’t count as an asset.

Some common assets that do count toward your equity are:

●         Cash – any payments you’ve received for products or services

●         Inventory – the amount of product your business currently holds

●        Property – land and buildings that your business owns

●        Equipment – machinery, vehicles or tech hardware owned by your business

●        Investments – any investment that can be turned into cash at any point, like stocks and shares

●        Accounts receivable (AR) – any expected revenue you are due from previous work, such as unpaid invoices 

●        Prepaid expenses – any services you’ve already paid for but haven’t yet received, like rent or insurance policies

After working out the value of your assets, the next step is to do the same with your liabilities. This can be defined as any money that your company currently owes.

Some common liabilities that count toward your equity are:

●        Accounts payable (AP) – any debts your business owes for products or services, so invoices you have yet to pay. This usually includes things like transport, materials, energy bills, products or licensing.

●        Accrued expenses (AE) – similar to AP, but a little different; it’s money your business owes that is recorded before it’s been paid. Usually, things like employee wages, bonuses, unused holiday or sick days, utilities that have yet to be billed, and purchases that have not yet been invoiced. As these are expenses that have not been billed, they’re usually estimates.

●       Taxes – any taxes on revenue or income that have yet to be paid

●      Debt (long and short term) – any money your business owes. Both are relevant, but it’s important to differentiate because short-term debts have a more immediate effect on your equity. Similar to AP and AE, but different because they are owed to an official lending body (like a bank).

●       Unearned revenue – payments from a customer for services or products you haven’t provided yet. Think of it as the inverse of AR; you’ve received payment but haven’t done the job yet.

Once you’ve got a detailed tally of both assets and deductions, determining your business’s equity is a simple case of adding everything up.

Knowing your equity is the first step for small businesses and sole traders that want to start growing. If you’d like a little more information about what to include when calculating your business equity, check out this article about assets and liabilities.

Calculating your business’ equity is simple in practice, but it does require careful bookkeeping. The 2-in-1 Countingup app allows you to manage your business finances more easily. 

Countingup is the business current account that comes with free, built-in accounting software. It comes with real-time profit and loss data, so you can quickly and easily understand your business’s performance and changes in equity at a glance.

The app provides automatic expense categorisation and a receipt capture tool so you can make sure your accounts are always accurate. The automated invoicing feature allows you to save time and get paid faster. 

Gain complete confidence in your finances and understand the changes to your business’s equity as you grow your assets. Find out more here and sign up for free today.