Control your equity to ensure the long-term future of your business

By Axelle Drack

Published: 22 October 2024

When you set up a company, equity is a solid source of finance, complementing debt.

But what exactly is equity made up of? What is it used for? How do you calculate its return, and what should you do if the amount is less than half the share capital?

All the answers to your questions (and more) in this article! Focus on this accounting entry.

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What is a company's equity capital?

Definition

In accounting, equity is the term used to describe the financial resources that a company possesses as a result of contributions made by the shareholders, as well as profits generated by the business and not distributed. On the balance sheet, equity is shown on the liabilities side.

The higher it is, the greater the company's capacity to cope with unforeseen events and exceptional or unforeseen expenses: it is therefore considered to be more sustainable.

🇬🇧 In English, equity is translated as shareholders' equity.

👆 Be careful not to confuse shareholders' equity with permanent capital, which includes shareholders' equity and long-term debt.

What is the purpose of equity in the balance sheet?

Its main purpose is to give an indication of the company's solvency. If equity is positive, it means that the company has more than it owes.

As a result, good equity enables the company to :

finance itself, especially when it has just started up and has not yet generated any profits,
access debt more easily by reassuring the banks,
obtain extended payment terms from suppliers,
reassure potential customers about the seriousness of the business,
pay dividends to shareholders when there is sufficient cash to do so,
to help the company value itself .

The difference between equity capital and share capital

Shareholders' equity should not be confused with equity capital, even though for most companies one is the same as the other.

Equity includes shareholders' equity, but also other less common forms of equity (for example, issues of redeemable shares).

Share capital is part of equity.

Composition of shareholders' equity

A company's share capital corresponds to the contributions made by the partners when the company is incorporated.

It may be :

in cash, in a dedicated bank account,
in kind: right of use of an asset, movable property, shares, real estate, etc.

▷ Account 101.

Net profit

Net income is obtained by subtracting all expenses from the company's income, and also deducting the amount of tax. It can also be obtained by adding together :

operating profit
financial income
and exceptional items.

A positive result is referred to as a profit, while a negative result is referred to as a deficit.

▷ Account 120 (profit) or 121 (loss).

Legal and statutory reserves

These reserves correspond to the portion of profits generated in previous years that have not been allocated to share capital or distributed as dividends. They are used to provide financial security for the company.

There are two types of reserve:

the legal reserve, which must be set aside at the end of each financial year to cover a minimum of 5% of profits, up to a maximum of 10% of share capital,
the statutory reserve, which is optional and may be imposed by the shareholders when they draw up the Articles of Association, specifying the terms and conditions. For example, a condition could be the achievement of a certain amount of profit.

▷ Accounts 10611 and 1063.

Retained earnings

When the shareholders meet to approve the accounts for the financial year just ended, they must decide how they wish to allocate the profit:

either by distributing it in the form of dividends to shareholders,
by transferring it to reserves
or by postponing the decision until the next General Meeting: this is referred to as retained earnings.

▷ Account 110 (profit) and account 111 (loss).

Other items

More exceptionally, the following may also be included:

share, merger or contribution premiums,
other reserves
investment grants
regulated provisions.

How do you calculate return on equity?

Step 1: calculating equity

There are two ways of calculating equity.

Option 1:

Equity = Company assets - Liabilities

Option 2:

Shareholders' equity = Share capital + Legal reserves + Statutory reserves + Retained earnings + Net profit

Step 2: Calculating average equity

Calculating average equity involves averaging the value of equity at the beginning and end of the year.

Average equity = (Equity at start of year + Equity at end of year) / 2

We can thus :

show changes at the beginning and end of the year,
give a smoother, more accurate representation of the level of equity for the year.

Step 3: calculating the return on equity ratio

The return on equity (ROE) ratio measures the return on equity.

Return on equity ratio = (Net profit / Equity) x 100

Step 4: Interpret the ROE

For example, if the ROE is 25%, this means that for every euro invested in share capital, 25 euro cents have been generated.

💡 A company is considered to be financially stable at a ratio of 20%.

Step 5: use other useful indicators

The debt/equity ratio can be interesting to calculate. The higher the ratio, the greater the debt burden.
The financial independence ratio (equity/permanent capital) is used to check the company's ability to finance itself from its own resources. At a minimum of 50%, the company is considered to be independent.
The fixed asset financing ratio (equity/net fixed assets) shows whether equity is able to finance assets and generate additional permanent capital. If it is greater than or equal to 1, this is the case.

What should be done if shareholders' equity is less than half the share capital?

You have found that your equity has fallen below half the share capital. This is also known as negative equity.

Is this a serious situation? How can you improve the situation?

The first thing to do is to consult the shareholders at an Extraordinary General Meeting (EGM), within 4 months of approval of the accounts showing the loss.

There are then two possible outcomes:

Solution 1️⃣: continue the business by reconstituting shareholders' equity. By opting for this solution, the partners undertake to regularise the situation before the end of the second financial year. If they fail to do so, the matter may be referred to the Commercial Court, which may grant an extension of 6 months, or the company may be dissolved.
You can reconstitute shareholders' equity by :
- making the profits needed to cover the losses
- increasing the share capital
- reducing the share capital.

Once the situation has been regularised, it is a good idea to inform the commercial court registry so that this is not mentioned in the Kbis extract.

Solution 2️⃣: dissolve the company early, in accordance with the conditions predefined in the company's articles of association.