Five Types of Equity Accounts for Businesses of Any Size

If you’re into handling the finances of your organization in any way, one thing that you might have spotted in the financial statements is ‘Equity’. Equity is what makes shareholders partial owners in the company, proportional to the number of shares they own.

If you’re not familiar with the term, don’t worry. We’re here to break it down for you. What is it? How to calculate equity? What are its types? Get to know all this and more in this blog.

What is Equity?

Equity is the assets minus its liabilities in a company. In simple words, equity is what is left after you’ve settled your liabilities.

It is the amount that shareholders will receive once all assets are sold and all liabilities are paid off. It is an important indicator of the financial soundness of the company. It is the first thing that a potential investor looks at.

How to calculate equity in business?

Consider XYZ Company, which has 2 lakh outstanding shares. If each share is valued at ₹75, the total market value of the company’s equity would be:

2 lakh shares × ₹75 per share = ₹1.5 crore.

Now that you understand calculating equity, let’s move on to understanding its key types.

Types of Equity Accounts

Here are 5 key equity accounts that you may be interested in knowing about - Common stock, preferred stock, retained earnings, treasury stock, and additional paid-in capital.

When we say “stock,” it simply refers to the ownership or equity in a company.

1. Common Stock

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Common stock or common share refers to the initial investment by stakeholders in the business as a form of capital. This gives the stakeholders rights to the business assets and the amount reflects the stakeholder’s value in the company. The stock owners have the right to vote on all important corporate decisions and also elect the board of directors.

Note that the total common stock capital can be determined by multiplying the number of outstanding shares with the stock’s par value. This stock is recorded at the face value of the stock. So, one million shares that hold a value of $1 each would reflect an entry of $1 million in the balance sheet.

Evidently, the owners of the common stock have more command over the business and how it’ll be run.

Also, in case of a liquidation event or bankruptcy, common stock holders are the last ones to receive assets. They receive assets only once the creditors and preferred stock holders have been paid.

2. Preferred Stock

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Next is preferred stock or preferred shares. These are usually issued to company investors in return for a fixed dividend. The dividend can either be a fixed amount or be defined as a percentage of the capital in the stock issuance certificate.

These stocks are considered as priority in terms of payment of dividends and for assets of the company if the company goes through liquidation.

Why preferred? Because any payment that is to be given, must be given to preferred shareholders before common shareholders are paid. So, yes, preferred shareholders get the right to claim an income from the firm they’re working with.

No voting rights are bestowed on preferred stock holders generally.

And here’s a tidbit! You can convert preferred stock to common stock after approval from the board of directors. Or, in some cases, it is decided beforehand on which date the preferred stock can be converted into common stock.

3. Retained Earnings

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Retained earnings are the total earnings of the company that remain after distributing dividend payments.

Why retained? Because these are retained by the company and not offered to shareholders as part of their dividend income. Who decides whether to retain this amount or to pay it out to the shareholders? Mostly, the top management.

Quite understandably, these earnings are more when the company is profitable and are less when the company is in loss.

The retained earnings can be utilized to fund expansion activities, like hiring more employees, investing in research and development, upgrading technology, or launching new marketing initiatives.

Positive retained earnings indicate that the company has consistently generated profit and reinvested in further growth, boosting overall performance and shareholder confidence.

4. Dividends

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A dividend is a part of a company's profit reserved for shareholders.

Let’s see how it works. A company generates earrings, which is profits remaining after covering expenses. This retained earnings, discussed above, can be used for future investments. But a company can also choose to distribute a part of this earnings with the shareholders, referred to as dividends.

Dividends can be of 2 types - Cash and Stock. Cash dividends are those that are paid to shareholders in cash. These are paid routinely like say quarterly or yearly. Stock dividends are those that are paid in company stock instead of cash, allowing the shareholders to own more equity in the company.

For instance, a company with an annual dividend of $5 per share and a stock price of $50 would have a dividend yield of 10% (calculated as $5 ÷ $50 = 0.10, or 10%).

5. Treasury Stock

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Treasury stock or reacquired stock refers to the outstanding stock of a company that is bought back from the shareholders.

Now, because these stocks have been repurchased and bought back into the company, the shareholders’ equity is reduced from the balance sheet. Also, treasury stock holders have no voting rights.

You might be wondering why a company may buy back stocks from the shareholders. Let’s see why.

First, it helps in raising capital for the company by reselling them. Second, it helps reducing the number of shares outstanding can increase stock price by increasing the earnings per share. Third, it helps reduce equity on the balance sheet, improving metrics like return on equity (ROE).

So, these were a few types of accounts that you might have come across while managing your business balance sheet or other financial statements. Next time you come across these terms, you'll feel more confident and informed, right? Good luck!