Both equity and capital are terms used in the world of finance to describe ownership in a business. These two terms are closely related but they have key differences depending on the context for which they are being used.
If you run a business or have an interest in the financial industry, it’s important to understand the difference between equity and capital.
In this article, we will define equity and capital and outline their differences.
What is Equity?
Equity refers to the claim that shareholders have in a business once all liabilities have been deducted. In other words, equity describes the amount of money the owners of a business will receive once the liabilities have been deducted from business assets. Equity is also referred to as owner’s equity or shareholder’s equity.
How to Calculate Equity
Mathematically, an equation of equity is represented as:
Equity = Assets – Liabilities
Suppose a company whose total assets are valued at $500,000 has liabilities of $150,000. The calculation of its total equity is:
$500,000- $150, 000 = $350, 000
A business is considered to have positive equity when it has enough assets to cover its liabilities. On the other hand, if a company’s total liabilities are greater than total assets, the company is said to have negative equity.
Why Is Equity Important?
Equity is included in a company’s balance sheet to help a company’s owners assess the overall value of a business. By knowing a company’s equity, you’ll be able to tell if it’s financially stable. Furthermore, equity represents the claim that shareholders have in a company, so each shareholder can know the amount to expect in case the company liquidates.
By analyzing a company’s total equity, investors can determine the worth of a company and decide whether they should invest.
The common items that impact a company’s equity include retained earnings, treasury shares, net income, and dividend payments.
What Is Capital?
Capital refers to the money or resources that a company’s owners invest in a business. Capital is used to purchase assets, run a business and fund its future growth. It can be cash, equipment, property, receivable accounts, or anything that increases a business’s ability to generate value. Capital is a subcategory of owner’s equity. There are two main sources of capital—debt financing and equity financing.
There are three types of capital:
- Economic capital: This is the amount of capital that a business requires to stay solvent considering its risk profile.
- Human capital: This refers to intangible resources that workers possess. These resources include knowledge, skills, education, training, intelligence, health, and more. Human capital is an intangible asset and it’s not listed on a company’s balance sheet.
- Natural capital: These are renewable and non-renewable resources owned by a business.
Conclusion
As you can see, these two terms can be confusing, especially for those who are new in the business. In a nutshell, equity is a business’s book value, which is attributable to the owners of the business; while capital is the money that a business’s owners invest in a business.
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