Equity (finance) Study Guide

📖 Core Concepts Equity – ownership interest in an asset or business; measured as Asset Value – Liabilities. Deficit / “Underwater” – when liabilities exceed the asset’s value; the excess is a deficit. Net Position (Gov/Non‑profit) – term equivalent to equity for public‑sector entities. Fundamental Accounting Equation – $ \text{Assets} = \text{Liabilities} + \text{Equity} $; must balance each period. Equity vs. Debt Financing – selling equity raises cash that does not require scheduled repayment; debt must be repaid with interest. 📌 Must Remember Equity = Market value of asset – Loan balance (single‑asset case). Deficit occurs when Liabilities > Asset value → asset is “underwater”. Non‑recourse loan: lender bears deficit risk; Full‑recourse loan: borrower remains liable for any deficit. Treasury stock is a contra‑equity account (reduces total equity). Retained earnings increase with net income, decrease with dividends and net losses. Limited liability shields owners from personal responsibility for business debts (assuming proper conduct). 🔄 Key Processes Compute Equity for a Single Asset Determine current market value of the asset. Subtract outstanding loan balance. Result = equity (positive) or deficit (negative). Update Balance Sheet After an Event Capital investment: increase cash (asset) and increase share capital / capital surplus (equity). Net income: increase retained earnings (equity). Dividends paid: decrease retained earnings (equity) and cash (asset). Stock repurchase: increase treasury stock (contra‑equity) and decrease cash (asset). Equity Financing vs. Debt Financing Decision If cash needed without repayment schedule → issue equity. If cash needed with tax‑deductible interest and ability to service debt → consider debt. 🔍 Key Comparisons Equity vs. Total Payments – Equity = market value – loan balance; total payments include principal + interest, which do not affect equity directly. Non‑recourse vs. Full‑recourse Loans – Non‑recourse: lender absorbs deficit; Full‑recourse: borrower remains liable for any shortfall. Treasury Stock vs. Preferred Stock – Treasury stock reduces equity (contra‑equity); preferred stock is an equity claim that sits above common stock in liquidation priority. ⚠️ Common Misunderstandings “Equity is the same as cash paid into an asset.” – False; equity reflects current market value, not cumulative cash outlays. “A deficit makes the owner owe money.” – In non‑recourse loans, the owner’s personal liability ends at the asset; deficit is a loss, not a personal debt. “Shareholder‑equity balance equals market price of the stock.” – Incorrect; market price depends on many factors beyond the accounting equity balance. 🧠 Mental Models / Intuition “Slice of the pie” – Think of total assets as a pie; liabilities are a slice taken away, and what’s left is the equity slice you truly own. “Balance‑sheet seesaw” – Assets on one side, liabilities + equity on the other; any move (e.g., dividend) must keep the seesaw balanced. 🚩 Exceptions & Edge Cases Negative equity (shareholder deficit) does not turn equity into a liability for owners; owners’ claim is simply wiped out. Government/non‑profit “net assets” may be classified into restricted vs. unrestricted reserves—still equity, but with usage constraints. 📍 When to Use Which Equity financing when you need capital without fixed repayment and are willing to dilute ownership. Debt financing when you can service interest, want tax‑deductible cost, and prefer to keep ownership intact. Non‑recourse loan for assets like residential real estate where borrower wants to limit personal exposure. Full‑recourse loan for business expansions where the lender requires borrower’s personal guarantee. 👀 Patterns to Recognize Equity increases with: cash contributions, net income, appreciation of asset values. Equity decreases with: cash dividends, stock repurchases (treasury stock), losses, and increases in liabilities that outpace asset growth. Deficit signals appear when the liability line exceeds the asset line on a balance sheet. 🗂️ Exam Traps Choosing “total payments” as equity – total payments include interest, which does not affect equity; the correct measure is market value – loan balance. Assuming a deficit creates personal debt – only true for full‑recourse loans; non‑recourse loans leave the borrower’s personal assets untouched. Equating “shareholder equity balance” with stock price – stock price is market‑driven; the accounting equity balance is just one input among many. Treating treasury stock as an asset – it’s a contra‑equity account, reducing total equity, not a resource the firm can use.