understand the meaning of the term equity

5.3 Limited Companies – Understanding Equity

1. What is Equity?

Equity (also called shareholders’ equity or owners’ equity) is the residual interest of the owners in the assets of a limited company after all liabilities have been deducted.

Equation

$$\text{Equity} = \text{Total Assets} - \text{Total Liabilities}$$

2. Limited Company – Key Features

• Separate legal entity: the company can own property, sue and be sued in its own name.
• Limited liability: shareholders are liable only for the amount they have paid for their shares. Their personal assets are protected.
• Advantages
  • Limited liability protects owners.
  • Perpetual succession – the company continues despite changes in ownership.
  • Easy to raise large amounts of capital by issuing shares.
  • Enhanced credibility with suppliers, banks and customers.
• Disadvantages
  • More costly and complex to set up and run (registration, filing annual accounts, audit requirements).
  • Profits are taxed twice – once at company level and again as dividends for shareholders.
  • Greater regulatory compliance and public disclosure.

3. Capital Structure (Components of Equity)

The Cambridge IGCSE (0452) syllabus expects you to recognise the equity items in the order shown below.

Component	What it represents
Ordinary share capital	Basic equity raised from ordinary shareholders (the “owner” shares).
Preference share capital	Shares that carry a fixed dividend and may be redeemable (must be bought back) or non‑redeemable (remain forever).
General reserve	Statutory or voluntary reserve created out of retained profit; cannot be distributed as dividends.
Retained earnings (retained profit)	Cumulative profit that has not been paid out as dividends.

4. Share‑Capital Terminology

• Issued share capital – total nominal value of shares that have been issued to shareholders.
• Called‑up share capital – portion of the issued capital that the company has requested shareholders to pay.
• Paid‑up share capital – amount that shareholders have actually paid. In most IGCSE questions the three figures are equal, but the distinction is important for larger companies.

5. Preference Shares – Redeemable vs Non‑Redeemable

Feature	Redeemable Preference Shares	Non‑Redeemable Preference Shares
Obligation to repurchase	Yes – the company must buy them back at a pre‑agreed date or on demand.	No – they remain part of equity for the life of the company.
Effect on equity when redeemed	Equity falls by the amount repaid (plus any premium).	Equity is unchanged because they are never redeemed.
Typical use	Fixed‑term financing where the company wants a known repayment date.	Permanent capital, often used to attract investors who want a fixed dividend.

6. Statement of Financial Position (Balance Sheet) – Layout Required by the Syllabus

Assets are listed first, then equity, then liabilities. Within each section items are ordered by liquidity (non‑current first, then current).

Statement of Financial Position (as at 31 December 20XX)
Non‑current assets
– Property, plant & equipment
– Intangible assets
– Long‑term investments
Current assets
– Stock (inventory)
– Trade debtors
– Cash and bank
Total assets
Equity and Liabilities
Equity
– Ordinary share capital (issued, called‑up, paid‑up)
– Preference share capital (redeemable / non‑redeemable)
– General reserve
– Retained earnings
Total equity
Non‑current liabilities
– Loan capital / debentures (long‑term interest‑bearing loans)
– Long‑term provisions
Current liabilities
– Trade creditors
– Accruals and other payables
– Tax payable
Total liabilities
Total equity and liabilities

7. Statement of Changes in Equity (Optional for IGCSE)

Understanding the flow of equity helps you answer questions about dividends, share issues and profit transfers.

Item	Amount (£)
Opening total equity	120,000
Profit for the year	30,000
Dividends paid	(10,000)
Issue of ordinary shares (paid‑up)	15,000
Transfer to general reserve	(5,000)
Closing total equity	150,000

Notice how profit increases retained earnings, dividends reduce retained earnings, and a new share issue increases paid‑up share capital.

8. Why Equity Matters

1. It shows the net worth of the company – a positive equity indicates that assets exceed liabilities.
2. Equity is a long‑term source of finance that does not have to be repaid (unlike most loans).
3. Changes in equity reflect the company’s performance (profit/loss), distribution policy (dividends) and financing decisions (share issues, buy‑backs).
4. Because shareholders have limited liability, their personal risk is limited to the amount they have paid for their shares.

9. Worked Example – Full Equity Breakdown

Assume the following figures for XYZ Ltd. (all amounts in £):

Equity component	Amount (£)
Ordinary share capital (issued, called‑up, paid‑up)	50,000
Preference share capital (non‑redeemable)	20,000
General reserve	5,000
Retained earnings – opening	30,000
Profit for the year	10,000
Dividends paid	(8,000)
Closing retained earnings	32,000
Total equity	107,000

If total assets are £180,000 and total liabilities are £73,000, the equity from the balance‑sheet equation is:

$$\text{Equity} = 180,000 - 73,000 = 107,000$$

The figure matches the sum of the equity components, confirming that the statement of financial position is correctly prepared.

10. Key Points to Remember

• Equity = Assets – Liabilities.
• Components (in syllabus order): ordinary share capital, preference share capital, general reserve, retained earnings.
• Issued, called‑up and paid‑up share capital are three stages of the same equity item.
• Redeemable preference shares can be bought back – this reduces equity when they are redeemed.
• Dividends reduce retained earnings; new share issues increase paid‑up share capital.
• Positive equity = solvency; negative equity signals financial trouble.
• Shareholders’ liability is limited to the amount they have paid for their shares.