Equity is the company’s capital that is made up of the company’s own financial resources.
Note: Equity is important to finance the company and how much equity is required depends on many different factors.
In corporate accounting, equity is the opposite of outside capital and describes the part of the total capital that is contributed by the shareholders, for example.
Where does the equity come from?
According to nonprofitdictionary, the shareholders’ equity arises when the company is founded in the form of cash or non-cash contributions. The minimum equity capital for corporations is stipulated by law and must currently be 50,000 euros (§ AktG) and for a GmbH according to § 5 Paragraph 1. GmbH 25,000 euros. Proof of payment must be available before the company is entered in the commercial register.
If a company is already registered, the equity arises in other ways and these include:
- Capital increase
- Activation of asset items
- Retention of profits
- Appreciation of assets
- Lower valuation of liabilities
- Issuance of shares
The equity on the balance sheet
The assets side (assets) and the liabilities side (liabilities) form the balance sheet and the source of funds is listed on the liabilities side. This can either be equity (own funds) or outside capital (external funds).
The different types of equity
According to § 266 (2) HGB, the following items of equity are listed:
- Subscribed capital
When founding, corporations, such as an AG (stock corporation) or GmbH (limited liability company), are obliged to make a capital contribution, which is also referred to as share capital or capital contribution. The subscribed capital will later be made up of this contribution and any subsequent capital increases.
- Capital reserves
Financial reserves that are retained from annual profit count as financial reserves and are classified as follows:
- Legal reserves :
Corporations have to build legal reserves, they are obliged to do so. For example, an AG has to withhold 5% of its retained earnings until this amounts to 10% of the share capital together with the capital reserves.
- Reserves for company shares
Here, reserves must be created in the amount of the total amount of the shares.
- Statutory reserves:
In their articles of association, companies can determine the formation of additional reserves themselves. Other revenue reserves: This includes all reserves that are not defined in the items above.
- Profit and Loss Carryforward
The profit carried forward is formed from the remainder of the previous year’s profit, which remains after the profit appropriation. The counterpart is the loss carryforward.
- Annual surplus / annual shortfall
The profit after deduction of all taxes is called the annual surplus. The opposite is the annual deficit (loss).
Which functions are performed by equity?
- Liability function
- The basis of creditor protection in the event of bankruptcy or civilization-related repayment.
- Founding function
- Equity is a prerequisite for a foundation
- Debt capital can only be raised if equity is available
- To finance the first investments in the foundation
- Necessary for constituent financing acts by the shareholders in corporations
- Loss absorption function
- The equity capital can be used to absorb losses
- The higher the equity, the longer losses can be absorbed without falling into a crisis
- Financing function
- Long-term property, plant and equipment can be financed with equity
- It is an important criterion for creditworthiness and necessary when it comes to raising outside capital.
- Determination of profitability
- The capital contribution is the higher, the more profit is generated with the same amount of equity.
- The profit distributed later corresponds to the shares of the equity contributions brought in by the shareholders
- Ruling function
- The yardstick is the equity that a shareholder has contributed, the greater his influence in the voting.
Equity and debt
The difference between equity and debt capital is particularly relevant for analysts and creditors. Even if there is only a small possibility of repayment, the position in the balance sheet belongs to outside capital. For this very reason, the provisions are also added to borrowed capital . This also applies to a performance-related interest rate.
In insolvency proceedings, equity and debt are best compared with one another. If there is backward equity that should have been brought in by a shareholder, then the insolvency administrator can demand that this be included in the estate. The whole thing is different, with a loan from the shareholder to the company or with outside capital from non-shareholders. Here the lender then has the opportunity to terminate the loan extraordinarily. If the loan has already been granted, then the claim for repayment becomes part of the insolvency ordinance and is thus part of the insolvency proceedings .
Benefits of Equity
A high equity ratio is generally seen as a positive signal. The equity ratio says that a company incurs little debt and that the financing consists primarily of its own resources. In addition, with high capital, the creditworthiness of banks increases. Another advantage is the company’s independence from external investors. The company can make investments with its own resources and is not dependent on funds from creditors or banks.
Disadvantages of equity
If a company is mainly financed with equity, this can also have disadvantages. Equity financing, for example, can require the addition of new shareholders. As a result, for example, the existing shareholders lose influence and co-determination rights.