Financial terms often seem obscure and difficult to understand when applied to real-life situations. Capital and equity are two such terms that are important to fully understand, but they can be quite confusing when used in finance and legal documents.
Capital is wealth. That includes money, land, equipment, buildings, and anything else that has intrinsic value that can be converted to cash or used as collateral for loans. When something is fully paid, it is said to be capitalized because it becomes an asset rather than a liability. It becomes a capital asset.
Equity is ownership expressed as the total value of the asset minus any liability against that asset, such as money borrowed to buy it or liens against the asset's value. When capital is added, equity increases.
Equity Capital in Your Personal Life
When you buy a house, you make a down payment of capital in order to purchase that house. Your down payment doesn't cover the total cost of the house, so you borrow the rest of the money from the bank. Your down payment of capital is your equity in the house, and the bank owns the rest. Over years of mortgage payments, you gradually increase the percentage of your ownership until you pay off the loan and own 100 percent interest in your house. You have increased your equity by using your earned capital to pay the bank.
Equity Capital in Business
Entrepreneurs start their companies by attracting investors who contribute their capital for an ownership share. This ownership share is called equity, and the contribution is called equity capital. Management of the company uses that capital to purchase plants and equipment. Stockholders use their capital to purchase stock in the company, and they each own a share or percentage of the company by virtue of their investment of capital.
Companies also borrow money and carry other liabilities in the form of accounts payable. The total value of the company minus the total amount of liabilities is what is called stockholder's equity, which refers to the actual amount of equity the stockholders have in the company.
Value of Equity Capital
Using earned capital to build ownership in an asset allows the owner to access that built-up equity to collateralize other borrowings. For example: If you have substantially paid down your mortgage or the value of your house has increased, you can borrow against the equity. Of course, when you borrow against the equity you add liability, which diminishes your percentage ownership.
Equity can be purchased using capital. Stockholders purchase equity using their cash capital. In the same way, a person can buy into a business by bringing her owned equipment into the business. The owned equipment is capital, just as much as cash is capital.
There are ways to purchase equity other than by using cash or other physical assets. Start-up companies often give people shares of stock in return for their work. This is called sweat equity--an example of how valuable a few hours of personal effort can be in some situations, even though in other situations it is just a few hours of time volunteered.