Why Is Common Stock Considered a Form of Equity?

Common stock and equity are key concepts in finance, representing different facets of company ownership and its financial structure. Understanding their distinct characteristics and intertwined relationship is important for understanding how businesses are financed and how ownership stakes are defined.

What is Common Stock

Common stock represents ownership in a company, making the holder a part-owner. This ownership typically grants shareholders rights, such as voting on corporate matters like electing the board of directors and major policy decisions, with one share often equating to one vote.

Common stock also represents a claim on a portion of the company’s assets and earnings. Shareholders may receive distributions of company profits through dividends, though these are not guaranteed and are decided by the board of directors. In liquidation, common stockholders are residual claimants, meaning they are last to receive assets after all creditors, bondholders, and preferred shareholders have been paid.

What is Shareholders’ Equity

Shareholders’ equity, often referred to as owner’s equity or stockholders’ equity, represents the residual interest in the assets of an entity after deducting liabilities. It essentially reflects the net worth of a company from the perspective of its owners. It is a component of the accounting equation: Assets = Liabilities + Equity.

Shareholders’ equity serves as a source of financing for a company, indicating the capital contributed by owners and accumulated profits. Components of shareholders’ equity include share capital (from common and preferred shares), additional paid-in capital, and retained earnings. Retained earnings, for instance, represent accumulated net income not distributed as dividends but kept for reinvestment or other purposes.

Common Stock’s Role in Equity

Common stock is considered a form of equity because it directly represents the capital invested by the common shareholders, forming a core part of a company’s overall equity. When issued, this capital becomes part of the shareholders’ equity section on the balance sheet. The value attributed to common stock contributes to the total equity calculation.

The “Common Stock” line item, along with “Additional Paid-in Capital,” is presented within the Shareholders’ Equity section of a company’s balance sheet. This placement highlights that the funds generated from issuing common stock are a direct reflection of the owners’ stake in the business. Common stock quantifies the ownership claim and the capital provided by investors to the company.