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:
| Component | Description |
|---|---|
| Share capital | The nominal value of shares issued |
| Share premium | The amount received above nominal value when shares are issued |
| Retained earnings | Accumulated profits not distributed as dividends |
| Revaluation reserve | Gains from revaluing fixed assets |
| Other reserves | Includes merger reserve, capital redemption reserve, and hedging reserves |
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:
| Account | Debit (£) | Credit (£) |
|---|---|---|
| Bank | 100,000 | |
| Share capital | 100,000 |
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:
| Account | Debit (£) | Credit (£) |
|---|---|---|
| Bank | 150,000 | |
| Share capital | 50,000 | |
| Share premium | 100,000 |
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:
| Account | Debit (£) | Credit (£) |
|---|---|---|
| Profit and loss account | 75,000 | |
| Retained earnings | 75,000 |
Payment of dividends:
| Account | Debit (£) | Credit (£) |
|---|---|---|
| Retained earnings | 20,000 | |
| Dividends payable | 20,000 |
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:
| Account | Debit (£) | Credit (£) |
|---|---|---|
| Land | 80,000 | |
| Revaluation reserve | 80,000 |
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:
| Capital and Reserves | £ |
|---|---|
| Called-up share capital | 100,000 |
| Share premium account | 50,000 |
| Revaluation reserve | 30,000 |
| Profit and loss account (retained earnings) | 185,000 |
| Total shareholders’ funds | 365,000 |
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:
| Reserve | Distributable? |
|---|---|
| Retained earnings (accumulated profits) | Yes |
| Share capital | No |
| Share premium | No |
| Revaluation reserve | No (until realised) |
| Capital redemption reserve | No |
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.
| Metric | Company A | Company B |
|---|---|---|
| Net profit | £60,000 | £60,000 |
| Average equity | £300,000 | £500,000 |
| ROE | 20% | 12% |
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.
| Metric | Low Gearing | High Gearing |
|---|---|---|
| Total liabilities | £150,000 | £450,000 |
| Total equity | £350,000 | £150,000 |
| Debt-to-equity | 0.43 | 3.00 |
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:
| Event | Effect on Equity |
|---|---|
| Profit for the year | Increases (retained earnings) |
| Loss for the year | Decreases (retained earnings) |
| Dividend payments | Decreases (retained earnings) |
| New share issue | Increases (share capital and premium) |
| Share buyback | Decreases (share capital, premium, or retained earnings) |
| Asset revaluation gain | Increases (revaluation reserve) |
| Asset revaluation loss | Decreases (revaluation reserve or income statement) |
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.