Equity is basically the amount that owners invest in a business. Equity primarily includes two components, one that owners directly invest and the other comes from the profit that a company makes. Against such a backdrop, we classify equity into two types – contributed or paid-in capital and earned capital. To understand the two terms – contributed capital and earned capital, it is crucial that we know what contributed capital vs earned capital means.
It constitutes the cash and other assets that investors put in the company in exchange for the shares. Or, in simple words, we can say it is the price that investors pay for their stake in the business. This capital includes the funds that a company gets from IPO, secondary offerings, direct listings, as well as the issue of preference shares. Moreover, it also consists of the assets or the reduction in liability in exchange for shares.
We also call this capital as paid-in capital. Talking about how we calculate this capital, it includes the amount that shareholders pay to purchase a stake in a firm. The paid-in capital is basically the face value or par value of the shares subscribed/purchased by the owners and investors. Any amount paid over and above the par value of the shares is called additional paid-in capital. Together with the two – paid-in and additional paid-in capital – constitute the contributed capital.
It is nothing but the portion of the company’s net income that it plans to retain. Or, it is the net income after paying the dividends accumulated over the years, if any. So, it won’t be wrong to call earned capital as the retained earnings. This earned capital/retained earnings together with paid-in capital forms the total equity of the company.
The earned capital balance will increase if a company chose to retain some (or all) of its net income. On the other hand, the balance will go down, if a company chose to distribute dividends more than the amount of net income, or if a company incurs a loss. In case of a loss, the balance will drop by the loss amount. The balance will remain the same if the company earns a profit, but distributes it all in the form of dividends.
Usually, a new company or a low growth company is unlikely to distribute dividends. Thus, such companies will have more earned capital, if they are earning profits.
Both contributed capital and earned capital are very important for a business. The former represents the investment from the owner and investors. And, the latter indicates whether or not the company is earning, and how much it is retaining. Together, the two make up Shareholder’s Equity.