Equity

• Equity refers to ownership of something. In a company, the equity is the proportion of the company's value that is owned by shareholders as opposed to what is owed to creditors. A company with 1 million shares of stock outstanding worth a market value of $20 would have market equity worth $20 million, even if the company itself may be worth $50 million. The rest of this value would be made up of debt obligations.
  
  When new equity is issued as a source of financing infrastructure, it is important to remember that the ownership of other equity holders will be diluted. For example, in a company with 1 million shares, if 1 million additional shares are created and sold to help finance the business, the original shareholders will have their ownership diluted by 50 percent.
  
  

Classes of Stock

• Typically, equity in a company is held in the form of stock. While there can be many types of stock, the classes are typically divided into preferred stock and common stock. Preferred stock gives a holder an ownership right in the company and is traded on stock markets, meaning that it's value can change due to market forces, just like common stock. Common stock, however, carries voting rights, meaning that holders of common stock can vote in elections to determine the composition of the board of directors. In the event of bankruptcy, preferred stockholders are repaid before common stockholders in bankruptcy proceedings, although both are subordinate to holders of debt in the event of bankruptcy.
  
  

Debt/Equity Ratio

• The relationship between equity capital and debt capital within a company is known as the debt/equity ratio. This ratio is often looked at by potential investors and market analysts as a way to gauge the financial health of a company. A debt/equity ratio that is too high suggests a company may have too much debt and too large of an interest payment burden to continue doing business profitably for a substantial period of time. Avoiding a higher debt/equity ratio may be one reason to focus on equity as a source of additional financing.
  
  

Financial Leverage

• Financial leverage is directly tied to a company's debt/equity ratio. The combination of debt and equity is the company's invested capital. The return on invested capital is the amount of profit the company is able to generate using that financing. These profits must be shared with equity holders in proportion to their level of ownership in the company. Therefore, the more equity is used to finance the company, the more those profits are divided and shared. However, if debt is used to finance additional operations, the company does not need to share additional profits with the lenders. It simply needs to make its interest payments. Therefore, a company that believes it can generate a return on invested capital greater than its interest rate on borrowed capital, may be better off financing operations with debt.