DEAR ALLEN: I am in an investment club, and the term “equity” comes up. I also hear it on financial network TV programs. I am embarrassed because I should know, but what is equity?
Confused Amateur Investor
DEAR CONFUSED: There is certainly nothing to be embarrassed about. Business has a language of its own, and in answering your question, it would be beneficial to learn some of that language. Specifically, this will involve some accounting definitions and concepts, so bear with me. Bullet points are:
- Basic accounting equation: Assets = Liabilities + Proprietorship. (Other names for proprietorship are capital, equity, net worth, or surplus. )
Everything has a place within this formula, and these items are displayed on a balance sheet, which reflects assets, liabilities and equity as of a single day.
- Assets. An asset is something you own.
There are generally four categories of assets:
a. Current assets. Assets that be exchanged for cash within 12 months, such as cash, inventory, accounts receivable, etc.
b. Long-term assets. Assets that are generally anticipated to be held over 12 months, such as certificates of deposit maturing after 12 months, notes receivable due after 12 months, etc.
c. Fixed assets. Long-term assets in the form of real property, equipment, etc.
d. Other assets. Assets that require amortization as a future expense (rather than a cash outlay), intangibles, etc. Examples would be deposits on utilities, prepaid expenses such as insurance premiums, deferred expense items, such as expenses prepaid to be amortized over a fixed period of time.
When we discuss the income statement, an important concept is to properly match income and expenses, and the use of deferrals is useful in applying pre-paid items to the appropriate accounting periods. The other assets category may also include assets that are owned by the business but which may not be used in day-to-day operations, such as a company airplane, vacation property for owners and employees, funds reserved for anticipated losses, etc.
- Liabilities. A liability is something you owe. There are generally three categories of liabilities:
a. Current liabilities. Liabilities that should be paid within 12 months.
b. Long-term liabilities. Liabilities that are due and payable beyond 12 months.
c. Other liabilities. Deferred income items, such as prepayments to you for products to be delivered or services to be rendered over a period of time.
- Equity (net worth). The difference between total assets and total liabilities.
While the foregoing comments describe information commonly displayed on the balance sheet (assets, liability and equity) as of one day and technically answer your question, it is helpful to know how the company produces the changes in those three categories.
That operational information is reflected primarily on the income statement, with additional changes being reflected on a less commonly used cash flow statement, which we will not discuss in this article. The income statement displays what happened in operating the company over a stated period of time (day, week, month, year, etc.). Income statement items include:
- Income-related items. (The term “revenue” is often substituted for “income.”).
a. Operating income. Income generated from the sale of goods and/or services in “the regular course of business.”
b. Other income. Income outside “the regular course of business,” such as interest for nonfinancial companies, dividends received on investments, sale of fixed assets, etc.
- Cost of goods sold. Costs are expenditures directly related to the sale of specific products. Costs are not expenses. Costs would include inventory that has been sold with the purchase price being specifically identified, such as cars and parts for automobile dealers, shirts and pants inventories for a clothing store, etc.
- Expenses.
a. Operating expenses. Payments or liabilities to others necessary to run the business. This category includes both fixed and variable expenses. Variable expenses vary with the amount of revenue produced, such as sales commissions, royalty payments, etc. Fixed expenses are relatively constant, regardless of revenue, such as rent, utilities, etc.
b. Other expenses. Expenses that are extraordinary to the “regular course of business,” such as interest paid (for most businesses).
- Gross profit (gross income). Total operating income less total cost of sales.
- Net operating profit/loss. Gross profit less total operating expenses.
- Other income. Income from nonoperating sales or activities, such as the sale of a fixed asset.
- Other expense. Described above.
- Net other income (expense). The difference between other income and other expense.
- Net profit/loss. Net operating profit (or loss) plus or minus net other income.
Income statement accounts reflect changes in the equity account(s) of the basic accounting equation (Assets = Liabilities + Equity) but are necessary for interested parties to know the results of operations. Both the balance sheet and income statement, along with the cash flow statement, if needed, should be reviewed to obtain a good viewpoint of where the company stands and how it is performing.
- Allen Wood Jr. is a seasoned Greenwood businessman. Send questions to him at excellententrepreneur1@gmail.com.
