Building equity through smart investments can have the potential for a big payout and be a great long-term strategy for establishing and growing wealth.
But how do you effectively build equity if you don't even know what it is?
Equity is the difference between the value of assets, and the value of liabilities of something owned.
If that is the case, there’s still good news: You’ve probably already built equity somewhere in your finances and you don’t even know it yet.
What Is Equity?
Assets are anything your business invests in and owns, such as computers, office equipment, vehicles, etc. Liabilities are things that your business must pay off such as accounts payable, mortgages and loans. Once you pay off all of the liabilities that you owe, you are left with the cost of equity.
Equity, put simply, is the actual amount of money that you own in an investment. The main goal in obtaining more equity is that when you pay off all the loans and other expenses, you are left with a profit.
While it might be difficult to keep track of what you owe and what you own in your business, equity management can be as easy as utilizing accounting software to make sure that you’re consistently building equity and getting a great return on your investments.
What are the different types of equity?
With a basic understanding of what equity is, you can start delving into the most lucrative and useful ways to utilize equity. The following types of equity are important to understand because these are investments that you can immediately make within your business as well as your personal life to improve your financial situation.
Home equity is defined as the value of your home minus the amount owed on your mortgage.
Have you ever tried to flip a home for profit? If so, then chances are you have built home equity before.
For example, if someone owns a home that is worth $100,000 (the asset) but borrowed $80,000 from a bank (which is opening a mortgage) to purchase the home (the liability), then you own $20,000 of home equity. Let’s plug it into the equity equation:
$100,000 (Home Value) - $80,000 (loan) = $20,000 (home equity you own at time of purchase; 20% home equity)
Because you paid $20,000 up front for the home that is worth $100,000, you own 20 percent of the home when you purchase it initially. Once you pay the bank back the $80,000 loan, then you reach full home equity.
Understanding your home equity is very important because it can be a major investment for any homeowner. Let’s say down the line that your home increases in value from $100,000 to $200,000. Not only has your home just doubled in value, but your equity stake has tripled from 20 percent to 60 percent.
Your home is $200,000, but you still only owe $80,000 from the home equity loan/mortgage. You just made a potential profit of $120,000 and could potentially keep making more money if your home keeps increasing in value.
The takeaway here is that building home equity has the potential to be incredibly lucrative. To keep building your home equity at a steady pace, it’s important to pay back the loans on your house so you can get closer to full ownership.
At the same time, building home equity can be as easy as purchasing a house and watching the market value naturally increase. While it may be challenging to manage your loans on your own, there’s plenty of loan software that can make sure you’re staying up to date with your loan payments.
|TIP: Learn how you can calculate debt to equity ratio in 2019.|
Stockholder's equity is the is the amount of assets given to shareholders after all of that company's liabilities have been taken care of.
Stockholders’ equity (also known as shareholders’ equity) can be a fruitful investment for small business owners as well as individuals looking to build long term equity.
When you decide to invest in a company’s stock or earnings, then you essentially become a stockholder with a certain amount of ownership (shares) in the company. Over time, the company will report if it has made a profit or recorded losses. If the company has made a major profit, then the stockholders may have hit the jackpot.
That profit will then flow into the stockholders’ equity. The company then has to decide if it will use this profit (return on equity) to invest back into the business or pay dividends to the stockholders. Dividends are just a fancy term for money that the you, the stockholder, will receive based on how many shares you own.
That being said, when you have stockholders’ equity in a company, it can prove very beneficial to both the company and the stockholder. As the company increases its retained earnings (a combination of its profits and investments) every year, your equity as a stockholder will grow incrementally which potentially means more money in your pocket.
As the company’s profits increase every year, this proves to the company’s investors that the company is financially stable with a high return on equity (ROE), proving the investors’ investment worthwhile.
The return on equity will always be the first thing that investors look for when they decide to invest in a company because it is a clear indicator that the company is profitable. If you see that a company’s ROE is 1.50, that means that for every dollar you put into the company, you will receive $1.50 back.
As with all investments, however, there is also risk. If the company records losses, then this can mean a loss on your investment. So do your research, and make sure that the company you decide to invest in has a high return on equity. And as with all financial planning, make sure to utilize any accounting & finance software to help you along your way.
Owner’s equity is essentially the exact same thing as stockholder’s equity, except instead of stockholders getting those dividend payouts, those payouts would go to the owners of the company.
Owner’s equity applies to companies that are not traded publicly on the stock market. These companies have no stockholders, and thus all of the equity goes straight to the owners or partners.
Owner’s equity is important for a couple of reasons. It’s vital to look at owner’s equity to understand a company’s financial health. The owner’s equity is the best indicator to whether a company actually made a profit.
It’s important to keep track of owner's equity because it can also show future investors that a company is healthy because the profits are greater than the losses. As with before, you will always want to keep your return on equity (ROE) high in order to attract new investors.
Attracting investors by showing them that your company is healthy is the best way to receive more funding for business expansion.
If you're a small-business owner in need of some fast money, then equity financing might be the way to go.
Here’s an example of how equity financing can help your business:
Say your company is doing well. After its first couple of years, your product is flying off the shelves. However, there’s one problem: You’re absolutely broke. Even though your product is selling well, all those profits are going toward your company’s liabilities, so your owner’s equity is very low. How are you going to get enough money to keep your company afloat so it can finally see a higher return on equity?
This is where equity financing comes into play.
If your company is showing promise but you aren’t turning a profit, then it may be time to look for investors to fund business expansion. So your company has two options: It can either get some investors to pay off the debt (debt financing), or you can sell stock/ownership in your company to the investors for cash that can be used to fund your company’s expansion (equity financing).
If you have ever seen the television series “Shark Tank,” then equity financing might ring a bell, as the entire show focuses in on small businesses trying to obtain equity financing.)
Why would you want to choose equity financing over debt financing? The answer is simple. Equity financing carries no obligation for you to pay back the investors. This means that all the cash you receive from equity financing can be invested back into your business.
At the same time, equity financing comes with you giving up some of the ownership of the company in order to obtain more funding. However, If the company tanks, there is no debt that follows because equity investors become part of the ownership when they give you equity financing.
This is equity financing in a nutshell. Your company is selling part of its ownership as well as part of its future. It’s selling a promise that your company will turn a profit and continue to grow so investors can gain back their investment in dividends over time.
You should always make prudent decisions when it comes to choosing between debt financing and equity financing. If your company only needs to pay off some short term debts for liabilities such as office equipment, then it might not be worth it to give up some ownership in your company for something that could be solved with loan payoffs over time.
Now it's time to build equity
Building equity can be as fruitful as it sounds. And while we are living in a generation that demands instant gratification, investing in your future can bring you financial security and peace of mind.
Before you get your feet wet, make sure to get some help along your equity journey.
Learn more about financial decisions in 2019 by understanding the fintech landscape and how it can benefit your business.