Many items are on a company's balance sheet and some accounts even vary from company to company because of the different businesses companies are in. One account that doesn't change is the equity account. There will always be one. Equity measures how much the owners have invested in the business either through direct contributions or through reinvested income.
Equity is owner's equity or basically the net change in capital contributions or withdrawals by owners. Beginning equity on the balance sheet is just how much the owners have initially put in the company. If an owner has invested $100, the equity would be $100. However, if $50 of that is in the form of a loan for which the company has to pay interest back to the owner quarterly, the company would have a $50 beginning equity and $50 in debt.
Equity has many purposes. For the banks, it shows how much money the company can lose before the banks start losing money. Looking at the trends in equity will help an investor see if the company is making money or not. It also helps an investor determine leverage ratios to see how much debt the company has and return-on-equity measures to see how good the company is at making money on its owners' capital.
There is no rule of thumb for investment purposes if a company has high equity. A high equity may mean the company has been making a lot of money but hasn't been efficient with its capital allocation. In that case, the company has too many assets and may be open to give some money back to shareholders either through share repurchases or through dividends. However, a high equity may also mean that the company is just trying to manage itself conservatively without having to worry about financial risk in addition to business risk.
Low or Negative Equity
Low or negative equity can mean one of three things. First, the company is not profitable and it would be best for the company to either liquidate or find a buyer. Second, the company may be doing a good job of managing its capital and has been able to give a lot of money back to its shareholders. Third, the company took on a lot of debt and added financial risk that adds an unnecessary level of financial risk to an investment.
Alex Shadunsky has a bachelor's degree in finance and is pursuing a Master of Business Administration from Indiana University. He has worked at Briefing.com as a junior equity analyst specializing in health-care stocks.