Equity

What it means

Equity is the part of liabilities and equity belonging to the owners: share capital, capital funds, the reserve fund, retained profit from earlier years and the current result, less uncovered losses.

In accounting terms it is assets minus liabilities. Economically it answers what the owners would be left with if the company sold everything at book value and settled every debt.

Equity is not money in the bank. A company can have high equity and still be short of cash if its assets are tied up in stock, receivables or machinery, and the reverse is also possible. The ability to pay on time is a question of liquidity, not of the size of equity.

How it works in practice

It grows through profit and members’ contributions and shrinks through losses and payouts on a profit distribution. That is why a distribution decision looks not only at the year’s profit but at total equity and at what is actually distributable.

On the balance sheet its ratio to borrowed funds is the first measure of stability a bank or a large customer looks at when assessing the risk of working with you.

When preparing the accounts we also check the ratio of equity to liabilities, because it decides whether the company is in crisis under the Commercial Code. If it is, we warn the director before the general meeting, since a crisis changes the rules, for instance on repaying members’ loans.

What to watch out for

Negative equity means liabilities exceed assets - the state of over-indebtedness, with statutory duties for the managing director including filing for bankruptcy. The remedy is a contribution, capitalising a member’s loan, or a turnaround, not delay.

Profit may not be distributed if equity after the payout would fall below share capital plus the reserve fund. A share paid out in breach of this rule must be returned by the members, and the director who allowed the payment is liable to the company for the resulting damage.