What is equity? When we look at a balance sheet we find equity and liabilities on the right side, and assets and cash at hand on the left side. The right side shows where the money is coming from. The left side shows where the money is going.
Equity is the company’s or institution’s own money. Liabilities are money from others, mostly in the form of short or long term debt. Equity in a start up company is often money either from the founders own savings or from investors, who invested start up capital in the form of equity. Sometimes investors invest in the for of a loan, but at risk. That means the money has to be paid back when profits are being made. In case of losses or a bankruptcy – however – their loan would be lost.
That is one of the functions of equity. In good times when profits are being made it builds up and grows. In bad times equity is being used to cover the losses. And in really bad times equity is being used up. And if finally no cash is available anymore, the company will be unable to pay for further salaries or to suppliers. It will probably have to file for bankruptcy if no investor can be found to invest more money.
Equity maybe can be described as the backbone of a company or initiative. It also has some aspects of the “I”, when compared to a human being. I mean to say that equity represents a certain strength, or power, or resource, to sustain existence also in difficult times. We say that an entrepreneur needs perseverance and standing in order to succeed. That is a certain “I” function: to stand up against the storm when necessary. Equity has a similar function. A relatively high equity position, like 40% or even 60% of total balance sheet, shows how healthy a company is and that many profits have been earned and have been saved into equity.
This needs to be critically checked with the level of investments. In some cases a high equity corresponds with too little investments in the past. In such a case too much of the profit has been saved. Those profits then will need to be invested into necessary refurbishment, new software, new buildings, and so on, in order to secure long term existence of the company.
But in cases where investments have been made on a healthy level and equity is still high then the company stands strong and will be able to sustain its self also in a crisis (which often comes unexpectedly and from the outside – meaning the leadership is and has never been able to influence that). In that sense equity represents the ability of a initiative to stay independent, to sustain itself, to maintain its own identity, to keep its own culture. Equity then is the representative of the identity of the company, much similar to the “I”, or identity, of a human being.
On the other hand when equity levels are low and debt is high and a crisis hits, then the company does not stand strong and is in danger of loosing its assets and identity to the bank or to debt-investors.
So there seems to be a certain role for the equity. Often I see that leadership is concerned with revenues, with day to day operations, with actual problems, but not with building up a very strong equity position over time, with a long term planning horizon. For many that seems to be a boring goal. I would advise to make your middle and long term goal to build up a strong equity position, while also taking good care for your cash at hand, representing a part of such equity, and maintaining a healthy level of renewal through investments. But all with the goal to increase the equity position and to strengthen the identity of the initiative in order to be able to sustain also in times of crisis.
Here are some recent statistics for reference equity positions: Equity in the German Mittelstand has increased from 25% in 2007 to 30% in 2015 (Handelsblatt 8/2017). And Mervyin King suggests in his book The End Of Alchemy (London 2017) that banks should have at least 10% equity. Many banks before the financial crisis had just 2 or 3% equity. He mentions that 100 years ago a bank would normally have at least 25% equity.