What is owner's equity and how to calculate it?

Starting a small business is a rewarding achievement, but it’s no easy feat. Since you own most everything that’s connected to your business, your responsibilities and tasks can feel endless. Being a business owner is unique—you own everything in your business except for your liabilities. This is where owner’s equity comes in: It’s one of the most important lines in your financial statements and represents your net worth.

Learn what owner’s equity is, how it affects you and your business, how to calculate it, as well as helpful examples.

• What is owner’s equity?
• What is the statement of owner’s equity?
• Key components of the statement of owner's equity
• How business type impacts owner’s equity
• Owner’s equity equation in accounting
• How to calculate owner’s equity
• Owner’s equity calculation example
• 12 ways to improve your owner’s equity
• Ensure your SMB is in good financial standing

What is owner’s equity?

Owner’s equity is the right owners have to all of the assets that pertain to their business. This equity is calculated by subtracting any liabilities a business has from its assets, representing all of the money that would be returned to shareholders if the business’s assets were liquidated. 

Finding out your owner’s equity can be helpful in determining your financial position—you’ll be able to compare the owner's equity from one period to another to figure out whether you are losing or gaining value. Owner’s equity is typically recorded at the end of the business’s accounting period. 

Owner’s equity:

• Increases when the owner (or owners) of a business increases the amount of their capital contribution. High profits from increased sales can also increase the amount of owner’s equity.
• Decreases when liabilities are larger than the assets. If this is the case, you may have to invest more money to cover the shortage.

What is the statement of owner’s equity?

The statement of owner’s equity is a financial report that shows the changes in the owner’s equity over a period of time. It details how much equity the business started with, what changed during the period, and how much is left at the end. Generally, it’s the second financial statement that’s generated after the income statement.

When is the statement of owner's equity used?

A statement of owner's equity is used in several key situations:

1. End of accounting period: An owner’s equity statement is typically prepared at the end of an accounting period (monthly, quarterly, or annually) to show the changes in the owner's equity over that period.
2. Reporting to stakeholders: This statement provides stakeholders, such as investors, creditors, and owners, with detailed information about the financial health and changes in equity of the business.
3. Analyzing financial performance: It helps analyze a business's financial performance by showing how profits, losses, and other factors, such as additional investments and withdrawals, have affected the owner's equity.
4. Supporting financial statements: The owner’s equity statement complements other financial statements, like the balance sheet, income statement, and cash flow statement, providing a comprehensive view of the business’s financial status.
5. Compliance and auditing: It is used for compliance purposes and during audits to verify that all changes in equity are properly recorded and reported.

Key components of the statement of owner's equity

• Beginning equity: The equity at the start of the period.
• Additions: Net income, additional capital contributions.
• Subtractions: Withdrawals by the owner, net losses.
• Ending equity: The equity at the end of the period reflecting all changes.

By preparing an owner's equity statement, businesses can effectively track and report changes in their equity, ensuring transparency and accuracy in their financial records.

Owner’s equity on a balance sheet

Owner’s equity is part of the financial reporting process. The amounts for liabilities and assets can be found within your equity accounts on a balance sheet—liabilities and owner’s equity are usually found on the right side, and assets are found on the left side. 

• Liabilities: Includes debts or other obligations in which your business owes money, whether it be now or in the future 
• Assets: The value of the items your business owns, like real estate and equipment

Note: If your business is acquired, the sales that the business made minus any liabilities that are owed are not transferred to the new owner during the acquisition.

What’s included in owner’s equity?

Several items are included in owner’s equity within the balance sheet, such as: 

• (+) The money invested into your business: When you put money or assets (e.g., equipment, vehicles, etc.) into your business, these investments directly increase your equity.
• (+) Profits your business has generated since it was founded: When your business makes a profit and you leave it in the company, that adds to your equity. It’s a good sign that your business is growing and building value.
• (-) Minus any money you’ve taken out of your business: Every withdrawal you make (e.g., paying yourself) reduces your equity. Taking out too much too often can lead to negative equity.
• (-) Minus any money lost by the business: Businesses face tough times and lose money, and these losses reduce equity. If the losses continue over time, it can make it difficult for your business to recover unless you take action (e.g., cut costs, increase revenue, etc.

This applies to businesses structured as sole proprietorships. However, if you’ve structured your business as a corporation, owner’s equity works a little differently. It’s usually called shareholders’ equity and there are additional factors to consider.

• (+) Outstanding shares: These are the total number of shares that have been issued to investors. When people buy shares, the money they pay helps grow the company’s shareholders’ equity. The more shares sold, the higher the equity.
• (+) Additional paid-in capital: This is the money investors pay for shares beyond their face value (i.e., par value). For example, if a share’s par value is $1 but someone pays $5, the extra $4 is additional paid-in capital. That extra amount adds to shareholders’ equity.
• (-) Dividends and distributions: When a corporation pays dividends to its shareholders, it lowers retained earnings and reduces equity because the funds leave the business.
• (-) Treasury stock: Sometimes, companies buy back their own shares. These treasury stocks reduce equity since the company uses its funds to repurchase shares.

Owner’s equity examples

Let’s look at a couple examples of how owner’s equity can change for your business.

Example 1: You own a local coffee shop. At the end of the year, you take a look at your financials and it shows your assets (e.g., coffee machines, cash, inventory, furniture, etc.) amount to $100,000. Your liabilities (e.g., loans, unpaid bills, debts, etc.) total out to $40,000.

When you plug this information into the equity formula (equity = assets - liabilities), your equity would be $60,000. 

Example 2: Let’s say you run a clothing store. At the end of the month, you check your financial information. Your assets equal $50,000, which can include inventory, cash, equipment, and anything else your store owns. Your liabilities amount to $20,000 due to loans, supplier invoices, and other outstanding payments. 

Using the equation, you can figure out your equity:

$50,000 (assets) - $30,000 (liabilities) = $20,000 (equity)

Can owner’s equity be negative? 

Yes, owner's equity can be negative. This situation occurs when a company's liabilities exceed its assets, resulting in a deficit. Here are some reasons why owner's equity might be negative:

• Accumulated losses. If a company has incurred significant losses over time, these losses can outweigh any profits and capital contributions, leading to negative owner's equity.
• High debt levels. When a company has substantial liabilities, such as loans and other debts, these can surpass the total value of its assets, resulting in negative equity.
• Excessive withdrawals. If the owner withdraws more money from the business than the profits it generates, it can deplete the equity and result in a negative balance.
• Large dividend payments. In corporations, paying out large dividends that exceed retained earnings can lead to negative equity.

Implications of negative owner's equity

Negative owner’s equity can impact the business in several ways:

• Financial health. Negative equity indicates that the company is in poor financial health and may face difficulties meeting its obligations.
• Creditworthiness. Lenders and investors may view negative equity as a red flag, making it harder for the company to secure financing.
• Bankruptcy risk. Prolonged periods of negative equity can increase the risk of bankruptcy or insolvency.

Example

• Assets: $50,000
• Liabilities: $70,000
• Owner's equity: Assets - Liabilities = $50,000 - $70,000 = -$20,000

In this example, the owner's equity is -$20,000, indicating that the company owes more than it owns.

Negative owner's equity is a serious issue that requires attention. It often necessitates strategic changes to improve the company’s financial position.

Additional forms of equity

Equity doesn’t just apply to companies—it can also refer to any type of ownership of something after taking out debts. Below are some common variations of equity to be aware of: 

• Stock: Any security that represents an ownership interest in a company
• Shareholder’s equity: Retained earnings or losses plus any funds contributed to the business by shareholders or the owner 
• Real property value: In real estate, this value represents the difference between a property’s fair market value and the amount someone still owes on the mortgage 
• Risk capital: The amount of money that remains after a business repays its creditors after going bankrupt or liquidating its assets

How business type impacts owner’s equity

Owner’s equity is typically seen with sole proprietorships, but can also be known as stockholder’s equity or shareholder’s equity if your business structure is a corporation. 

Depending on how a company is owned or operated, owner’s equity could be attributed to one owner or multiple owners. 

Sole proprietorship

This is a private form of ownership—the sole proprietor, or owner, has possession of all the company’s equity.

Partnership

This refers to a business that has more than one owner. In this case, owner’s equity would apply to all the owners of that business. Net earnings are split among the partners according to the percentage of the business they own. 

Corporation

Corporations are formed when a business has multiple equity ownership, but unlike partnerships, corporation owners are provided legal liability protection. These owners are known as stockholders. 

Owner’s equity equation in accounting

Owner’s equity represents the value that remains after you subtract all your liabilities from your assets. Here’s the formula to calculate this:

Equity = assets - liabilities

This equation helps you see what’s left after paying off everything you owe. If your assets are worth more than your liabilities, you’ve got positive equity, which is a great sign for your business. If your liabilities are higher than your assets, your equity will be negative, which could mean financial trouble.

You must understand your company's worth—the owner’s equity—in order to effectively plan and make decisions. To do this, follow this step-by-step process:

Step 1: Understand the concept

Owner's equity is a critical financial metric that shows what portion of the company truly belongs to you. It's calculated using this simple formula:

Equity = assets - liabilities

This equation tells you how much your company is worth after all debts are paid.

Step 2: Gather your financial statements

Before calculating, ensure you have your company's most recent balance sheet. This document lists all your assets and liabilities in one place.

Step 3: Identify total assets

Find the "Total Assets" line on your balance sheet, which includes everything your company owns that has monetary value, such as:

• Cash and cash equivalents
• Accounts receivable
• Inventory
• Property and equipment
• Investments

Step 4: Identify total liabilities

Locate the "Total Liabilities" line on your balance sheet. This number represents all the debts and obligations your company owes, including:

• Accounts payable
• Loans
• Mortgages
• Accrued expenses

Step 5: Perform the calculation

Now, subtract your total liabilities from your total assets:

Owner's Equity = Total Assets - Total Liabilities

Step 6: Interpret the results

The resulting figure is your owner's equity. A positive number indicates that your company has more assets than debts, while a negative number suggests more debts than assets.

Step 7: Review periodically

Remember to recalculate your owner's equity regularly, as it can change with fluctuations in your assets and liabilities.

Owner’s equity calculation example

Let's say your business has:

• Assets worth $65,000 (including $40,000 in land, $15,000 in equipment, and $10,000 in cash)
• Liabilities of $15,000 ($10,000 bank loan and $5,000 credit card debt)

Your owner's equity would be: $65,000 (Assets) - $15,000 (Liabilities) = $50,000 (Owner's Equity)

This $50,000 represents your company's net worth and the portion of the business that truly belongs to you.

12 ways to improve your owner’s equity

Boosting your company's net worth is a strategic process that requires careful planning and consistent effort. Here are several effective strategies to enhance your owner's equity and strengthen your business's financial position:

1. Increase your assets

• Invest in new equipment or technology
• Expand your inventory
• Acquire valuable real estate or property
• Boost your cash reserves through improved cash flow management

2. Reduce your liabilities

• Pay down existing debts
• Negotiate better terms with creditors
• Refinance high-interest loans
• Implement stricter credit policies to reduce accounts receivable

3. Enhance profitability

• Increase sales through marketing and customer acquisition
• Improve profit margins by optimizing pricing strategies
• Reduce operating costs without sacrificing quality
• Diversify your product or service offerings

4. Reinvest profits

• Instead of withdrawing profits, reinvest them into the business
• Use retained earnings to fund growth initiatives

5. Streamline operations

• Implement efficient processes to reduce waste and increase productivity
• Utilize technology to automate tasks and reduce labor costs

6. Manage working capital effectively

• Optimize inventory levels to avoid overstocking or stockouts
• Improve accounts receivable collection processes
• Negotiate better payment terms with suppliers

7. Seek strategic partnerships

• Collaborate with other businesses to share resources and reduce costs
• Form alliances that can lead to new revenue streams

8. Invest in employee development

• Train and upskill your workforce to increase productivity and innovation
• Implement performance-based incentives to motivate staff

9. Focus on customer retention

• Implement loyalty programs to encourage repeat business
• Provide excellent customer service to reduce churn

10. Explore new markets

• Expand into new geographical areas or customer segments
• Develop new products or services to meet emerging market needs

11. Optimize Tax Strategies

• Work with a tax professional to identify legal ways to reduce tax liabilities
• Take advantage of available tax credits and deductions

12. Leverage intellectual property

• Develop and protect valuable patents, trademarks, or copyrights
• License your intellectual property for additional revenue

Improving owner's equity is an ongoing process that requires consistent effort and strategic decision-making. Regularly review your financial statements and adjust your strategies as needed to ensure continuous growth in your company's net worth.

Ensure your SMB is in good financial standing

An owner’s equity total that increases year to year is an indicator that your business has solid financial health. Most importantly, make sure that this increase is due to profitability rather than owner contributions.

Be sure to take advantage of QuickBooks Live and accounting software to help with your statement of owner’s equity and other bookkeeping tasks.