What is equity?
Equity is the owners' stake in a business: what would be left from its assets after every liability had been paid off.
What equity means
Equity is the bottom section of a balance sheet. It follows the accounting equation: assets minus liabilities equals equity. For a limited company, equity is usually called shareholders' funds or capital and reserves. For a sole trader it is often shown as the capital account.
In a small UK company, equity normally has two parts:
- Share capital: the money paid for shares when they were issued, often just £1 or £100
- Retained earnings: the profits kept after Corporation Tax and dividends since the company started
Example
A design company has these balances at its year end:
| Item | Amount |
|---|---|
| Assets (laptops, cash, money owed by clients) | £68,000 |
| Liabilities (suppliers, VAT, Corporation Tax) | £23,000 |
| Equity | £45,000 |
The £45,000 equity is made up of £100 share capital and £44,900 retained earnings.
Why it matters for your business
Equity tells you whether the business is solvent on paper. Negative equity, where liabilities exceed assets, is a warning sign for lenders and suppliers and can raise questions about whether the company is a going concern.
For directors, equity has a practical limit: a company can only pay dividends out of retained earnings. If the retained earnings figure is negative, there are no distributable reserves and a dividend would be unlawful, even if there is cash in the bank. Many director's loan account problems start with dividends taken when reserves were not there.
Equity vs cash
Equity is not money in the bank. A company can have £45,000 of equity but only £5,000 of cash if most of its assets are equipment or unpaid invoices. Equally, a company can hold plenty of cash while owing more than it owns. Read equity alongside cash flow.
Equity and investors
In investment terms, "raising equity" means selling new shares. The money increases share capital (and share premium if shares are sold above their nominal value), and the investors take a share of ownership in return.
Equity for sole traders and partners
A sole trader's balance sheet shows a capital account instead of shares. It starts with the money you put in, increases by each year's profit and falls by your drawings. If you draw more than the business earns over time, the capital account goes negative, which usually means you have been funding your lifestyle from business borrowing or unpaid bills.
Common questions
No. Profit is what the business earned in one period. Equity is the cumulative total of the owners' investment and all profits kept since the start, less losses and dividends. A profitable year increases equity; a loss or a large dividend reduces it.
It means liabilities are bigger than assets, so the company could not pay everyone it owes from what it owns. It is not automatically insolvency, but directors should take advice, avoid paying dividends and watch cash closely.