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Definition of Financial Equity:
is the difference between the value of an individual's or entity's assets and liabilities. It is also referred to as “net worth”. Financial equity is more commonly called "equity", but Higher Rock Education uses the term financial equity to distinguish it from the use of equity as it relates to fairness.
Financial equity is a measure of ownership. Lewis owns a home valued at $200,000, but he owes $120,000 on his mortgage. Lewis’s equity would equal $80,000 – the value of his home less the amount he owes. Likewise, a business owner’s financial equity (or net worth) equals the amount the business is worth less what is owed. This means that if a business has $700,000 in assets and $500,000 in debts, the owners have $200,000 in financial equity in the company. This is reflected on a balance sheet where all of the assets are listed on the left side and the liabilities and financial equity are listed on the right side. The sum of the liabilities and equity must equal the assets. For example, assume Tye’s Laundry holds the following assets:
Land and Buildings $500,000
Now assume Tye’s Laundry has the following liabilities:
Washers and Dryers $170,000
Total Assets $700,000
Wages Payable $50,000
Taxes Payable $20,000
Equipment Loans $150,000
Mortgage Balance $250,000
Total Liabilities $470,000
Tye’s ownership interest, or financial equity, equals $230,000 (assuming Tye is the only owner).
When expressed on a balance sheet, the financial statement would be:
Financial equity can be negative. For example, many homes were “underwater” following the financial crisis. In these cases, the values of the homes were less than the amount owed. Owners could not sell because they owed more than they could net from the sale. Businesses can also have negative equity when their liabilities exceed their assets. These companies may declare bankruptcy.
Shares of stock are called “equity” because each share represents an ownership interest in the company. Stock markets are frequently referred to as equity markets.
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