Equity is the capital which belongs to the owners (proprietors, partners). It is the main carrier of the entrepreneurial risk. Its share in total capital is an indicator of financial guarantee of the enterprise or organization.
Equity is not a constant variable, but it varies depending on the economic result in given period. If the enterprise achieves profit (and if it isn’t consumed), the equity grows. If the enterprise is in the loss, equity decreases.
Equity is divided into several items:
- Capital - consists of cash as non-monetary contributions of the partners to the company. In companies with limited liability and in joint stock companies, the capital is created mandatory and the amount is entered in the Commercial Register. For corporations, the capital arises from the share issue. The capital increase can be provided by new cash and non-monetary contributions of members, gaining a new partner (e.g. a private investor), or by issuing or increasing share value. The reduction in equity can be limited to the amount of capital
- Capital funds - capital of the enterprise acquired from outside (but not foreign capital), in particular, this includes share premium (extra charge, the difference between the achieved selling price of shares and nominal value of shares on issue)
- Revenue Reserves - funds created from profit internally, includes a reserve fund (legally prescribed), or other funds (given by the Articles of Association)
- Retained Earnings - part of the profit after tax levy, which is not distributed to owners, but it serves to further business. Retained earnings are then allocated to various reserve funds. It may not be made up of cash
Use of the equity in practice: Within the financial structure of the company, it is necessary to assess and analyze, in particular, the relation between equity and liability. Debt ratios are used for such assessment. Sufficient amounts of equity capital for the business gives the impression of a reliable and strong partner. For the majority owner is also the management easier. Under certain circumstances, using its own capital for business can be cheaper, if the owner does not claim high earnings. In such a situation can be otherwise cheaper to use foreign capital due to tax optimization (interest deduction from the tax base).