What is Equity?

Equity represents the residual interest in a company’s assets after all liabilities have been deducted. It is sometimes called shareholders’ funds, net assets, or owners’ equity. In the fundamental accounting equation, equity occupies the balancing position:

Assets - Liabilities = Equity

For UK limited companies, equity is governed by the Companies Act 2006 and reported in accordance with FRS 102 (or IFRS for listed companies). Understanding equity is essential for interpreting a company’s balance sheet and assessing its financial strength.

Components of Equity

Equity in a UK company typically comprises several distinct elements:

Share Capital

Share capital is the nominal (or par) value of shares that have been issued by the company. When a company is incorporated, it declares an authorised share structure. As shares are issued to investors, the nominal value is credited to the share capital account.

Example: A company issues 100,000 ordinary shares with a nominal value of £1 each:

Under the Companies Act 2006, every company must maintain a register of members showing who holds the shares and the nominal value of each class of share.

Share Premium

When shares are issued at a price above their nominal value, the excess is credited to the share premium account. This reserve is non-distributable, meaning it cannot be paid out as dividends.

Example: Issuing 50,000 shares at £3 each, nominal value £1:

The share premium account can only be used for specific purposes, including:

• Writing off the expenses of issuing shares
• Writing off any discount on the issue of debentures
• Paying up bonus shares

Retained Earnings

Retained earnings (also called the profit and loss reserve) represent the accumulated profits of the company that have not been distributed to shareholders as dividends. Each year, the profit or loss from the income statement is transferred to retained earnings.

Year-end transfer of profit:

Payment of dividends:

Retained earnings are the primary source of distributable reserves from which dividends can legally be paid.

Revaluation Reserve

When a company revalues its fixed assets upwards, the gain is credited to the revaluation reserve rather than the income statement. This reserve is non-distributable.

Example: Land originally purchased for £200,000 is revalued to £280,000:

Under FRS 102, if the revaluation model is adopted, the asset must be carried at fair value with regular revaluations to ensure the carrying amount is not materially different from fair value.

Equity and the Balance Sheet

On a UK company’s balance sheet , equity appears at the bottom under the heading Capital and reserves:

This total must equal total assets minus total liabilities. If it does not, there is an error in the accounts.

Distributable Versus Non-Distributable Reserves

The Companies Act 2006 draws a critical distinction between reserves that can be used to pay dividends and those that cannot:

A company may only pay dividends out of accumulated realised profits less accumulated realised losses. Directors must ensure sufficient distributable reserves exist before declaring a dividend. Paying a dividend from non-distributable reserves is unlawful under sections 830-831 of the Companies Act.

Equity Ratios and Analysis

Return on Equity (ROE)

ROE = Net Profit / Average Shareholders’ Funds x 100

ROE measures how effectively the company uses equity to generate profits. A higher ROE indicates more efficient use of shareholders’ capital.

Debt-to-Equity Ratio

Debt-to-Equity = Total Liabilities / Total Equity

This ratio indicates the balance between debt and equity financing. A higher ratio means greater financial leverage and potentially higher risk.

Book Value Per Share

Book Value Per Share = Total Equity / Number of Shares Outstanding

This shows the accounting value attributable to each share. While it differs from market value, it provides a useful reference point.

How Equity Changes

Equity changes through several mechanisms during an accounting period:

Statement of Changes in Equity

Under FRS 102, companies must present a statement of changes in equity as part of the financial statements. This reconciles the opening and closing balances of each component of equity and shows all movements during the period.

Negative Equity

A company has negative equity when its total liabilities exceed its total assets. This means the balance sheet equation produces:

Assets - Liabilities = Negative figure

Negative equity is a serious financial warning sign. It may indicate that:

• The company has accumulated losses exceeding its invested capital
• Liabilities have grown to unsustainable levels
• Assets may be overstated or impaired

Directors of UK companies have specific duties under the Companies Act when the company’s net assets fall below half the called-up share capital. Section 656 requires directors to call a general meeting to consider whether any steps need to be taken.

Equity in Different Business Structures

Limited Companies

Equity in a limited company comprises share capital and reserves as described above. Shareholders’ liability is limited to the amount unpaid on their shares.

LLPs (Limited Liability Partnerships)

In an LLP, equity is represented by members’ capital and current accounts. There is no share capital. Profits are allocated to members according to the LLP agreement.

Sole Traders and Partnerships

For sole traders and partnerships (not covered by the Companies Act), equity is the owner’s capital account, reflecting initial investment plus accumulated profits minus drawings .

Equity and Corporation Tax

Equity transactions generally do not have direct corporation tax implications. Share issues, dividend payments from distributable reserves, and revaluation gains credited to reserves are not taxable events. However:

• Dividends received by a UK company from another UK company are generally exempt from corporation tax
• Interest on loans (debt, not equity) is tax-deductible, creating a tax advantage for debt financing over equity
• Share buybacks may have tax implications for the selling shareholder

This tax treatment influences the capital structure decisions that affect the financial management of the business.

Equity and the Accounting Equation

The accounting equation ties every element of the financial statements together:

Assets = Liabilities + Equity

Every journal entry recorded in the ledger either maintains or rebalances this equation. A debit to an asset must be matched by a credit to a liability, equity, or revenue account. A debit to an expense ultimately reduces equity through the income statement.

Understanding equity in this context makes it clear that every business transaction, no matter how routine, has an impact on the shareholders’ position in the company.