Control your equity to ensure your company's long-term viability

By Axelle Drack

Published: October 22, 2024

When setting up a company, equity is a solid source of financing, complementing debt.

But what exactly is equity made up of? What is it used for? How do you calculate its profitability, and what should you do if it amounts to 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, shareholders' equity refers to a company's financial resources, derived from contributions made by associates and retained earnings generated by the business. On the balance sheet, shareholders' equity is found 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, capital and reserves are translated as equity.

👆 Be careful not to confuse 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. Positive shareholders' equity 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, reassuring banks,
obtain extended payment terms from suppliers,
reassure potential customers of the seriousness of the business,
pay dividends to shareholders when there is sufficient cash to do so,
to help with valuation.

The difference between equity capital and share capital

Shareholders' equity should not be confused with equity capital, even if for most companies one is equal to the other.

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

Share capital is included in shareholders' equity.

Composition of shareholders' equity

A company's share capital corresponds to the contributions made by the partners at the time of incorporation.

It may be :

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

▷ Account 101.

Net income

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 income,
financial income,
and extraordinary income.

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 income generated in previous years that has 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 at a minimum of 5% of profits, and up to a maximum of 10% of share capital,
the statutory reserve, which is optional and can be imposed by the partners 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 associates meet to approve the accounts for the year just ended, they must decide how they wish to allocate the profit:

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

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

Other items

More exceptionally, these items may also include:

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

How do you calculate return on equity?

Step 1: Calculating shareholders' equity

There are two ways of calculating shareholders' equity.

Option 1:

Shareholders' equity = Company assets - Liabilities

Option 2:

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

Step 2: Calculating average equity

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

Average shareholders' equity = (Shareholders' equity at beginning of year + Shareholders' equity at end of year) / 2

We can thus :

show variations at the beginning and end of the year,
give a smoother, more accurate representation of the year's equity level.

Step 3: calculating the return on equity ratio

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

Return on equity ratio = (Net income / Shareholders' equity) x 100

Step 4: Interpret ROI

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

💡 The company is considered 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 (shareholders' equity/permanent capital) shows the company's ability to finance itself. At a minimum of 50%, the company is considered to be independent.
The fixed asset financing ratio (shareholders' equity / net fixed assets) shows whether shareholders' 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 to do if shareholders' equity is less than half the share capital?

You've noticed that your shareholders' 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 trading by rebuilding shareholders' equity. By opting for this solution, the partners undertake to regularize the situation before the end of the second financial year. If they fail to do so, the company may be referred to the Commercial Court for an extension of 6 months, or the company may be dissolved.
You can reconstitute shareholders' equity by :
- making the necessary profits to cover losses,
- increasing share capital,
- reducing share capital.

Once the situation has been regularized, it is advisable to inform the Clerk of the Commercial Court so that this is not mentioned in the Kbis extract.

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