Equity is defined as “the residual interest in an entity’s assets that remains after liabilities have been subtracted.” In other terms, equity is the ownership stake in a corporation that shareholders have.
Types
There are two main types of equity: common equity and preferred equity.
Common equity: It is the most basic form of equity and refers to the ownership stake that common shareholders have in a company. Common equity is typically divided into two categories: primary and subordinated.
Primary common equity is the value of ownership interests held by common shareholders who have the first claim on a company’s assets. This type of equity is also called as senior common equity.
Subordinated common equity is the value of ownership interests held by common shareholders who have a subordinate claim on a company’s assets. This type of equity is also called as junior common equity.
Preferred equity: It is a more specialized form of equity that gives preferred shareholders certain privileges, such as priority over common shareholders when it comes to dividends or the liquidation of assets. Preferred equity is typically divided into two categories: cumulative and non-cumulative.
Cumulative preferred equity gives holders the right to receive cumulative dividends. This means that if organization doesn’t pay dividends in one year, the dividends will accumulate and must be paid in full before common shareholders can receive any dividends.
Non-cumulative preferred equity does not give holders the right to cumulate dividends. This means that if organization doesn’t pay dividends in one year, the dividends are simply forfeited.
A company’s equity position is also a key factor in determining its credit rating. A company with a strong equity position is more likely to receive a higher credit rating than a company with a weak equity position. Equity is also an important consideration in financial modeling. When forecasting a company’s future cash flows, it is important to consider the impact of equity dilution. Equity dilution can take place when organization issues new shares or when existing shareholders sell their shares.
Another important aspect of equity is that it represents the ownership stake that shareholders have in a company. This means that equity holders are entitled to a portion of the company’s profits, as well as a portion of the organization resources in event of liquidation. Equity is an important part of accounting because it provides a basis for valuing a company. Equity is also important for tax purposes, as it can be used to reduce a company’s tax liability.
Example
If oraganization has $100,000 in assets and $50,000 in liabilities, organization has $50,000 in equity. If organization has 100 shares of common stock outstanding and a share price of $10, the company has $1,000 of equity. If organization has 100 shares of cumulative preferred stock outstanding with a par value of $100 and a dividend rate of 5%, the company has $10,000 of equity.