Equity is a term that you may hear a lot about with relation to your finances. However, you may not understand what it is or why it is important. Understanding what it is and learning how to calculate equity can help you make better financial decisions. With this in mind, you may be ready to learn how to calculate equity.
Before you can learn how to calculate equity, you need to understand what this term means. This is a financial term that describes the value of an asset less any debts that you owe on it. As you can see, equity describes your net financial investment in a specific type of asset rather than the total value of an asset.
What Types of Equity Are There?
You can use equity in relation to almost any type of asset of value that you own. These are a few of the more common types of equity that you may hear about:
1. Vehicle Equity
You can calculate vehicle equity by subtracting your current outstanding loan balance on the vehicle from the vehicle’s market value.
If you owe more money on the loan than the vehicle is worth, you have negative equity, or you are upside down on your loan.
If you sell the vehicle when you have negative equity, you will need to pay money out-of-pocket to pay off the remainder of the loan.
2. Home Equity
You can calculate home equity by subtracting your current home mortgage balance from the current property value. You may also find that you have negative equity on your home.
However, making a larger down payment and paying more than the minimum monthly payment on any of your asset loans can help you to avoid being upside down on your assets.
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3. Investment Equity
For other types of investments, you may calculate equity by taking the net income and dividing this figure by the revenue.
You may also determine the return on equity of an investment by multiplying the equity multiplier by the asset turnover and the net profit margin.
How to Calculate Equity
A closer look at how to calculate equity for investments may be in order. So that you understand how to more strategically use equity analysis for your financial benefit.
For example, you need to know how to calculate the equity multiplier, the asset turnover and the net profit margin if you want to learn what the return on equity of an investment is.
The asset turnover is calculated by taking the revenue and dividing this figure by the assets.
The equity multiplier is calculated by dividing the assets by the shareholders’ equity.
The net profit margin is calculated by dividing the net income by the revenue.
When these three components are multiplied together, you will compute a return on equity for a specific investment. Your ability to understand how to use return on equity and your understanding of what this concept is can help you make more strategic investment decisions.
For example, it can help you avoid investing in a company that is heavily burdened by debt. Or, a company that cannot support the debt that it has accumulated based on its income or worth.
Applications of Equity
You may be wondering exactly how learning how to calculate equity and how to apply this concept can benefit you. Equity may seem like a somewhat distant concept. However, it is an important concept that can help you to make decisions over the years.
By learning how to analyze equity properly in different, you can take thoughtful action. These are a few of the more common applications of equity that may impact your life.
1. Knowing When to Sell
One important factor that you can analyze when you know how to calculate equity is the ideal time to sell an asset. For example, when you learn more about the equity that you have in your car or home, you can determine if you should hold onto or sell them.
You can also determine when to sell them to maximize your return. If you have negative equity in your car, you may need to pay down the loan balance further over the course of the next few months before you sell it.
You may need to use the equity that you have in your home as a down payment for a new home or to pay off credit card debt. You must be able to accurately calculate equity to know how much money you have available to spend.
2. Determining How Much Money to Invest or Pay Up-Front
You may also project equity going forward for different types of investments. For example, before you buy a new home, you may want to estimate the amount of equity you will have over the course of the first few months of ownership.
If you make a small down payment on the home, you may find yourself upside down on the property if the market value declines even slightly. Remember that there may also be costs that come with selling a home, such as real estate agent commissions.
Therefore, you may want to establish a certain amount of equity in the property up-front. You should do this to minimize the chance to go negative with your investment when all costs are considered.
You can take this same effort when buying a new car, a new boat or any other item of value with a loan. While many assets appreciate in value over time, some may decline in value. When your debt is paid down slower than equity accrues, the possibility of being upside down is significant.
3. Determining Which Investments to Buy
Being able to analyze your investment opportunities properly is also possible when you know how to calculate equity. You can use the return on equity to help you determine which investment opportunities are sound and which may be riskier for you to make.
The ability to understand the risks and possible rewards associated with an investment can help improve your financial investments. You can also apply analytical principles to monitor the growth of equity in different investments.
For example, if you notice that the equity return of an investment is declining, you may decide to sell it. Likewise, if your analysis of return on equity indicates that a company has heavy debt, you may decide to invest your funds elsewhere.
As you can see, there are numerous ways you can use equity to improve your financial decisions over the years. You can analyze equity for assets and investments alike. You can also review it in different ways to make strategic moves over the years. Now is a great time to review equity for your current assets and investments. By doing so, you may identify important steps that you can take to improve your financial situation going forward.