As a small business owner, it is no easy feat to own and operate an independent company. Still, you also own everything connected to your business, except for liabilities owed to other people. These business assets are known as equity, but what does that mean exactly?
What is owner’s equity?
Simply put, equity refers to the worth of something. This means the owner’s equity represents the net worth of a business that belongs to the owner. It is the total value of a company’s net assets after all liabilities have been deducted.
How do you calculate equity?
To calculate a company’s worth, you need to know its assets and liabilities. The accounting formula required to do this is as follows:
EQUITY = ASSETS – LIABILITIES
The company’s assets (resources) minus liabilities (what the company owes others) is equal to the total net worth of the company, also known as owner’s equity. This is attributable to one or multiple owners, depending upon how the company is owned.
Owner’s equity in a balance sheet
Owner’s equity of a company can be found along with liabilities on the right side of the balance sheet, and assets can be found along the left side.
Typically, the items that are included in the owner’s equity on the balance sheet are:
- Money invested into the business by the owner or
- Profits of the business since its inception
- Minus money the owner has taken out of the business or
- Minus money owed to others.
What are examples of owner’s equity?
Generally, equity begins with the original contribution to the organisation by way of assets, typically cash and/or assets used within the business.
For example, suppose the owner contributed $100 of cash and a machine that cost $200 for their product’s manufacturing. In that case, the company’s assets would be $300, and the equity would be $300 as well.
Net income increases equity over time. Equity fluctuates as the business operations generate net income or loss. Net income is the excess amount of a company’s revenue over expenses for a specific period.
If a business is making money, it is generating net income. Like owner investment, net income causes the owner’s equity in the enterprise’s assets to increase.
Reinvesting earnings in your business vs distributing earnings
Equity and debt are two forms of capital. Capital reflects the sources of financing needed to acquire assets for a business.
Suppose the previously discussed entrepreneur, who possesses $300 in equity, decides to buy a second machine. However, they do not have the funds to do it themselves, so they ask the bank for a loan.
This loan is a debt of the company. Once they receive the $200 loan and buy the second machine, their assets increase to $500, but their equity remains the same $300. At the same time, they take on liabilities of $200.
With two machines, they generate twice the amount of operating profit, doubling their operating earnings, minus interest on the loan, allowing them to grow their equity account.
If the equity is the company owner’s share of assets, then the debt is the capital deployed in the business by other people or by the bank.
A decrease in owner’s equity is when the owner, or entrepreneur, withdraws some of those earnings to support themselves while operating the business, such as their wage.
What is a statement of owner’s equity?
A statement of owner’s equity reflects these increases and decreases in owner’s equity over a specific period. As noted above, this statement will reflect an increase in owner’s equity for the operating income generated by the business. It will also include the decreases from the distribution of wages to fund the owner’s lifestyle.
Therefore, these financial statements record all contributions and incomes, as well as withdrawals and expenses of the company.
Business organisation and ownership
The legal organisation of a business is often driven by the number of parties owning the business. A sole trader is one person who is legally responsible for all aspects of their business. In contrast, multiple owners of a company are legally organised as partnerships or corporations. Thus, the worth of a business reflects the aggregation of all (one or more) owner’s equity.
This private form of ownership means that one person holds a company. The sole trader has possession over all of the equity of the company.
A partnership refers to a business with two or more owners/partners. As a result, the owner’s equity appears as an aggregation of the equity of all partners. Each partner, or owner, possesses a separate capital account, including the partner’s investments, withdrawals and corresponding share of the company’s net income/net loss from operations.
Generally speaking, net earnings will be divided between the partners, depending on the percentage of the business each partner owns.
Similar to partnerships, corporations are often formed with multiple equity owners. However, corporations differ from partnerships in that they provide legal liability protection to the owners, which facilitates transferability of ownership interests. These numerous owners of a corporation are referred to as shareholders.
Shareholders, also known as stockholders, are the investors who have purchased shares of stock in a company, thus becoming owners of that company. There can be between one and a limitless number of shareholders, depending on the corporation’s size. Therefore, the owner’s equity of a corporation is referred to as the aggregate shareholder’s equity.
Once the shareholders have been paid their dues at the end of an accounting period, what is left over is known as retained earnings, which can then be funnelled back into the corporation to keep it growing.
Is shareholder’s equity the same thing as owner’s equity?
When one person or sole trader owns a company, it is known as the owner’s equity. However, when a company or corporation is owned by multiple people, or shareholders, it is referred to as shareholder’s equity.
What is owner’s equity capital?
Capital refers to the funding sources that are used by the owners to acquire the assets used to run a business. There are two main types of capital: equity capital and debt capital. Equity capital is the funding of a business by investors, while the owner’s equity capital is the funding of the company by the owner. Debt capital refers to funds loaned to the company from a bank to fund the purchase of assets used in the business.
How do I calculate an owner’s equity statement?
A statement of owner’s equity covers the increases and decreases in the company’s worth. It can be calculated by using the accounting formula of net assets minus net liabilities equals owner’s equity.
Creating this statement relies on the accurate recording and analysis of your company’s balance sheets. Accounting software can help your small business do this. With the QuickBooks reporting feature, create professional-looking balance sheets covering assets and liabilities to gain a clear picture of the equity in your business. Try our free 30-day trial now.