How does debt become equity
Definition of equity: Equity in the balance sheet (e.g. of companies) is the difference between the assets (assets) and the debts. Equity is available to the company indefinitely and there are no repayment obligations. The debt capital, which includes the company's debts, is complementary to equity. Equity and debt together make up the liabilities in the balance sheet.
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Definition of equity
There are various explanations and definitions of equity. It can be defined as a residual variable as above or based on its origin. The following points of view are common:
- Equity as a residual: The company's assets are valued at market value. For example, hidden reserves are dissolved. The company's debts are deducted from the assets valued in this way. The remaining equity remains at market values. This value can be viewed as a company value.
- Equity from a balance sheet point of view: The capital is calculated according to accounting rules. For Swiss companies, these are typically the requirements of the Code of Obligations. Other accounting rules are Swiss GAAP FER or IFRS. They are more complex and are used by larger companies.
- Equity by origin: Another perspective is the consideration of the equity capital from the origin of the funds. Who made which contributions when a new company was founded or when a capital round? For example, the founder initially contributes CHF 30,000 to the company and 2 friends contribute CHF 10,000 each. The shares are distributed proportionally and so the founder owns 60% of the company and his two friends 20% each.
Equity positions according to the Swiss SME chart of accounts
In the SME chart of accounts Switzerland, the equity accounts are shown differently, depending on whether the balance sheet of a stock corporation or GmbH, a sole proprietorship or a partnership is shown.
Source: Swiss chart of accounts for SMEs - official school version
Return on equity: the profitability ratio
The return on equity is the key profitability indicator for equity providers. The return on equity in% shows how high the "interest" on the equity invested is for the time horizon under consideration - typically one year. As with all profitability indicators, a profit variable is set in relation to a balance sheet size. It measures the profitability of the company.
Return on equity formula:
Quirks: The return on equity is increased through higher profit or through a reduction in equity (e.g. through repayment to shareholders). The return on equity can thus be easily manipulated, e.g. by taking on more debt (leverage effect) or by more or less depreciation.
Equity ratio: the stability index
TheEquity ratio (or the degree of self-financing) indicates the share of equity in the total capital (balance sheet total) of the company, in%.
To assess a company, many financial indicators analyze the company's capital structure and thus its stability. The less equity capital meets the obligations, resp. the amount of debt on a company's balance sheet, the more susceptible the company becomes to changes in its environment, such as a decline in sales. On the other hand, the higher the leverage ratio, the higher the return on equity. This means that the equity ratio should be as high as possible for security reasons and as low as possible from a return point of view. Good corporate governance is responsible for carefully weighing these effects.
Peculiarities: Investors with a longer time horizon prefer companies that have a sufficiently high equity ratio to survive extreme downturns. The level of the equity ratio depends on the business model and the range of fluctuation in business profits.
Other important key figures are summarized here.
The equity capital in SMEs typically comes from the owners themselves. In the case of start-ups, the founders put most of the capital into the new company. Other sources of equity are:
- Family friends: In addition to the main owners and founders' own funds, the equity in most companies comes from the entrepreneurial environment. This in the form of equity and the transfer of the corresponding company shares or in the form of subordinated loans.
- Business angles: Wealthy individuals provide equity. They are often organized in networks such as SICTIC for ICT companies or businessangels.ch. However, they usually expect a clear exit plan, that is, a way in which they can exit again at a higher price.
- Private equity: Private equity companies are available for larger investments. They also expect a typically 5-year plan until an exit.
- Equity crowdfunding: A larger number of people invest in the company's equity. They can be found on crowd investing platforms.
Cost of Equity: the cost of money
Equity costs are imputed interest on equity. They are the shareholders' expectation of compensation for the risk they have taken. They are expectations with regard to future profit or dividend distributions. The expectations are formed based on the risk inherent in the investment with regard to alternative, comparable investment opportunities.
Equity in Swiss SMEs
On average, the equity share of the total capital of Swiss companies is 30% according to figures published by the Federal Statistical Office 2020 for the year 2018. The equity share of selected industries:
- Information & communication technology: 59.5%
- Retail 36.6%
- Gastronomy 29.9%
- Building construction: 25.0%
- Hotel 15.9%
- Banks 9% (Clientis banks)
Read about our survey on the popularity of debt capital in Swiss SMEs.
👉🏼 Excel sheet for calculating key figures
We have prepared a practical Excel sheet for you. With this you can calculate the most important profitability, liquidity and capital structure figures of a company with minimal effort.
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