Equity is the portion of capital available to companies that comes exclusively from their partners, shareholders or, even, from the profit obtained from their operations. It is an important component from an accounting point of view, since it forms what is known as the company’s “equity” – that is, it is the capital that it truly holds and that should not be returned to any creditor.
Equity is part of the initial contribution of every company. It is a mandatory element of the bylaws, being known at the time as social capital . It is through it that the business activities begin, guaranteeing working capital and (mainly) breath for its survival until the turnover becomes substantial. Thereafter, it also adds this factor and is seen as the company’s own resources.
Even so, equity is not always sufficient for the operation of all the projects necessary for the profitability of the business. And it is precisely to make them viable that managers choose third party capital – an external contribution, provided basically through loans and financing from financial institutions. The union between third party capital and equity is responsible for the emergence of what is known as capital structure .
What are the advantages and disadvantages of choosing equity?
As we will explain in the section itself, companies are free to choose the best financial management strategy for their development. After the first contribution (the share capital ) they can choose to decrease or increase the amount corresponding to equity.
Knowing this, realize that there are some specific advantages linked to the choice of this source of funds. Some of them are:
- There is no payment of interest on the amount:after all, the form of return on investment for the partners is the division of profits;
- There is more freedom for the application of capital:when dealing with the capital of third parties, companies are constantly under pressure from the need to pay the debt. Because of this, they tend to opt for apparently more profitable projects (although not always in line with their strategic proposal). With equity, this pressure in relation to the return on investment is mitigated;
- The risks are assumed by both parties:that is, by the company and the partner in question. When there is a loss, there is nothing to be said about profit sharing or return.
However, not everything is roses. The main disadvantage linked to equity is linked to its finitude. We explain: equity, in its exclusive use, limits the company’s expansion. Thus, he is not always able to finance essential projects so that it can keep up with market needs and take advantage of specific opportunities.
What is the capital structure? What is the difference between equity and third party capital?
Precisely to face these limitations imposed by the exclusive use of equity, companies (especially teams related to financial and accounting management) started to design a model in which both resources (both inside and outside the organization) properly balanced. Thus, the capital structure emerged .
Comprising equity (which we discuss in this article) and third party capital, it is ubiquitous in every organized company.
While equity comes from the company’s partners and shareholders (and from the positive balance of its operations), third party capital comes from banks and suppliers, who lend money through traditional loans, financing and other debts.
The main difference between them is not, however, in its origin, but in the obligation it generates for the borrower: while in the first, investors receive in the form of a Profit division, in the second the payment is independent of business performance – and, oh, must be done with interest!