Investments: Assets Or Equity? Understanding The Basics Of Finance

Equity and assets are both financial terms that provide value to a company and help it operate and generate profits. While assets represent the value a company owns, equity represents the investment provided in exchange for a stake in the company. Both are recorded on the balance sheet, but they are distinct from each other and are not subsets of one another. This article will explore the differences between investments as assets or equity and how they relate to each other.

Equity investments

Equity investors seek capital gains and/or capital dividends, expecting their investments to rise in value. This can strengthen a portfolio's asset allocation by adding diversification. Equity funds offer a diversified investment option with a minimum initial investment amount.

There are various types of equity investments, including direct equity investments, mutual funds, and exchange-traded funds (ETFs). Direct equity investments are often made in early-stage and growth-stage companies, especially in low and lower-middle-income countries, to support their development and operations.

When investing in equities, it is important to consider the associated risks, such as market risk, credit risk, liquidity risk, and political risk, among others.

Equity is calculated by subtracting total liabilities from total assets, and it is used in key financial ratios like ROE. Equity represents the value of an investor's stake in a company, and it gives shareholders voting rights and the potential for capital gains and dividends.

Long-term investments

For individuals, long-term investments are often associated with retirement planning. The power of compounding, combined with a long-term outlook, enables individuals to take calculated risks, aiming for higher overall returns. This approach is particularly effective when combined with a diversified portfolio, which helps to reduce long-term volatility.

When it comes to companies, long-term investments play a pivotal role in diversifying asset portfolios, ensuring steady income streams, and supporting business expansion. They can also enhance a company's financial strength and improve its credit rating.

Some examples of long-term investments include:

• Growth stocks: These are typically high-growth tech companies that reinvest their profits into the business, offering the potential for high investment returns.
• Stock funds: These funds offer a collection of stocks unified by a specific theme, providing a more stable and diversified investment option.
• Bond funds: These funds contain a variety of bonds from multiple issuers, offering a safer and more stable investment option.
• Dividend stocks: These are stocks that pay out regular dividends, making them attractive to investors seeking a consistent income.
• Value stocks: These stocks are cheaper relative to their earnings and tend to perform well when interest rates are rising, offering the potential for above-average returns with lower risk.
• Target-date funds: These funds automatically adjust their asset allocation to become more conservative as the investor's retirement age approaches.
• Real estate: Investing in property can be a lucrative long-term strategy, providing stable income and the potential for significant capital gains.
• Small-cap stocks: These are stocks of smaller companies with high growth potential, such as Amazon in its early days.

Shareholder equity

The total assets include both current and non-current assets. Current assets are those that can be converted to cash within a year, such as cash, accounts receivable, and inventory. Non-current assets are long-term assets that will generate benefits for more than a year, including investments, property, and equipment. Total liabilities consist of current and long-term liabilities. Current liabilities are debts typically due for repayment within a year, while long-term liabilities are those due beyond a year.

While shareholder equity and assets are different, they are both essential for a company's financial records and decision-making. Shareholder equity provides investors and analysts with insights into the company's financial health and helps them evaluate the quality of its financial ratios.

Private equity

The private equity industry has grown rapidly, and it tends to be most popular when stock prices are high and interest rates are low. Private equity funds have a finite term of 10 to 12 years, and the money invested in them is tied up for the duration. The funds typically start to distribute profits to their investors after a number of years.

• General Partner (GP) – The General Partner initiates and administers the fund, selects and manages the investments, collects money from investors, and distributes money back to investors when investments are sold.
• Limited Partners (LP) – The investors in the fund are the limited partners.
• Target companies – The private companies in which the fund invests are the target companies.

Limited Partner stakes are considered illiquid, as there are no formal exchanges or secondary markets for stakes in PE fund shares. In addition, Limited Partners may be subject to a 'lock-up period' during which the General Partner will deploy the committed capital to make strategic changes to target companies within the portfolio. Lock-ups mean that investors cannot liquidate their position until the end of the fund's term, usually up to ten years or more.

Equity calculations

The Shareholder's Equity Formula

The fundamental formula for calculating shareholder's equity is:

> Shareholder's Equity = Total Assets – Total Liabilities

This formula is derived from the accounting equation, which reflects the relationship between a company's assets, liabilities, and equity.

Balance Sheet Analysis

To calculate shareholder's equity, you can refer to a company's balance sheet, which summarises its financial position. Here's a breakdown of the steps:

• Locate the company's total assets on the balance sheet for the specific period.
• Identify the total liabilities, which should be listed separately.
• Subtract the total liabilities from the total assets to arrive at the shareholder's equity value.
• Note that total assets will equal the sum of liabilities and total equity (as per the accounting equation).

Current and Non-Current Assets

When calculating total assets, it's important to consider both current and non-current assets:

• Current Assets: These are highly liquid assets that can be converted into cash within a year. Examples include cash, accounts receivable, and inventory.
• Non-Current Assets: These are long-term assets that cannot be easily liquidated or consumed within a year. Examples include investments, property, equipment, and intangible assets like patents.

Liabilities

Liabilities represent the debts and obligations a company owes. They are divided into current and long-term liabilities:

• Current Liabilities: Debts typically due for repayment within one year, such as accounts payable and taxes payable.
• Long-Term Liabilities: Obligations due for repayment over a year or more, including bonds, leases, and pension obligations.

Understanding Equity

Equity represents the residual value that belongs to the shareholders or owners of a company after all debts are paid off. It reflects their stake in the company and is crucial for assessing financial health and potential returns.

Alternative Calculation

While less common, shareholder's equity can also be calculated as the company's share capital and retained earnings minus the value of treasury shares.

Equity in Private Companies

It's worth noting that private companies, unlike public corporations, are not required to disclose financial statements. However, they can still calculate their equity position using the same formula as public companies.

Frequently asked questions