Owner’s equity in a business is an important measure to help owners understand the value of their stake in the business, along with how the business is doing financially. It specifically shows the portion of a company’s value that is held by the owners, whether it’s an entrepreneur, partners, or shareholders. In essence, it’s considered to be a company’s “net worth.” In larger businesses that are publicly traded, owner’s equity is more commonly referred to as “shareholders’ equity.”
Essentially, it represents the amount of money that would be returned to the owner or a company’s shareholders if all assets were liquidated, all debts were paid off, and money was remaining.
Owner’s equity is found on the balance sheet and is calculated by subtracting the company’s liabilities from its assets.
Owner’s Equity = Total Liabilities – Total Assets
This is because liabilities will need to be paid in the event of a sale or liquidation. Liabilities include debts your business owes such as loans, accounts payable, and mortgages. Assets, on the other hand, would include anything your business owns, such as cash, cars, machinery and intellectual property. Any remaining funds can then be collected by the owner.
As mentioned, owner’s equity is a valuable indication of a business’s financial health, but it’s also a great way to track whether the company is gaining or losing value over time. An increasing equity indicates a healthy and growing business that has access to funds to activities like investing. On the other hand, a negative owner’s equity shows that a business has more liabilities than assets, and it can be a sign that a business may be in trouble.
It’s also a great way to demonstrate the business’ value to lenders when seeking external capital, or trying to raise capital from outside investors. Businesses can compare owner’s equity from one period to another to determine positive or negative trends, as well.
Remember, however, that owner’s equity shows you the book value of your business, not the market value. Book value is the amount you paid for an asset, where market value is the price of an asset when you sell it (which can appreciate or depreciate). Therefore, market value can be different from book value, so using owner’s equity to show you what the market value is of your company isn’t a fair representation.
Let’s dive in more deeply to different parts of owner’s equity below.
What is Included in Owner’s Equity?
For many businesses that are privately-owned, like sole proprietorships and partnerships, the following categories are generally found.
- Capital investments from the owners – Increases owner’s equity
- Retained earnings generated by the business – Increases owner’s equity
- Retained earnings contribute to positive equity growth and increase the overall value of the business. This is important, because this capital can be used for reinvestment or paying down debt.
- Money withdrawn by owners – Decreases owner’s equity
- While it can be common for owners to withdraw money from their business for their share of the yearly earnings, if they take too much, it can start pushing a business’s equity into negative territory. This is something to be watched, because long-term negative equity can’t be sustained and the business will eventually be unable to pay the liabilities they owe.
- Losses generated by the business – Decreases owner’s equity
- If the business operations are consistently losing money, the business will struggle to survive. It will erode equity unless big changes are made or the business gets a cash injection to turn things around.
- Decreased liabilities – Increases owner’s equity
- By refinancing high interest rate debt or reducing employee costs, you will keep more money in the business.
For larger businesses that are publicly traded, the “shareholders’ equity” has additional transactions that can raise or lower the equity, including:
- Dividends and distributions – Decreases shareholders’ equity
- Since these are paid from a company’s net income, it’s one additional thing that won’t make it into retained earnings. However, comparing retained earnings to net income is useful because a business may show a positive net income, but larger dividends and distributions. If this continues, it can create a negative cash flow and hinder equity.
- Outstanding shares – Increases shareholders’ equity
- Businesses may sell additional shares to the public to raise capital, which will increase equity.
- Treasury stock – Decreases shareholders’ equity
- This occurs when a business repurchases their stock from investors, which decreases owner’s equity. However, by reacquiring stock, companies are now spending money to reduce their dividend payments in the future, which can lead to higher retained earnings and, in turn, higher owner’s equity.
How Does Owner’s Equity Aid in Business Planning?
Owner’s equity does a great job in providing insight into a company’s financial performance. It shows the net increase or decrease in equity over a given period, which allows business owners and managers to assess the financial health of the business.
For example, if there has been a significant decrease in equity, it may be a sign of financial trouble. A business owner may need to improve the company’s financial performance, such as reducing expenses or finding additional financing.
Owner’s equity also shows a business owner information on the sources of equity financing. It shows the amount of capital invested by owners, or outside investors, which can help managers decide how to allocate resources and use these funds in the best way possible. Would it be best to invest in new equipment? Expand a product line? Hire additional staff?
Additional ways owner’s equity aids in business planning are:
- Monitoring Trends
- Is there a decreasing balance in owner’s equity? It may be a trend of negative income over time, which may require a closer look to determine the cause.
- Capital Contributions
- Is additional funding needed? Should you get more funding from an owner or outside investors? This can be important things to think about when you are looking for financing or investors.
- Evaluating Net Income or Loss
- Better understand how your business is performing and what you may need to do to improve financial performance.
- Withdrawals
- Monitoring continued withdrawals can help you understand the cash flow of your business and whether it’s affecting your financial health.
- Accurate Records
- Accurate record-keeping is important for owner’s equity. This includes recording all transactions such as capital contributions, net income or loss and withdrawals, as well as all financial transactions.
- Comparison with Industry Benchmarks
- Comparing your Owner’s Equity with industry standards can provide great insights as to how your business is doing. It can also help you identify areas of strength and areas of improvement that can be useful when seeking investors or other forms of financing.
- Business Diversification
- Positive equity means you have the capital to potentially fund new business ventures, which could lead to increased profits.
- Expanding The Business
- Positive equity can allow you to expand certain projects in the business, but negative equity will help you decide if you need to shrink or downsize different areas of the company.
- Borrowing Decisions
- Depending on your equity, it can influence the willingness of lenders to approve loans or if you would be viewed as a high risk.
- Staffing Decisions
- A positive or negative equity could help you decide if you have the budget to add to your staff or if you need to think about layoffs or downsizing.
- Supports Tax Preparations
- Business owners can use the information used to build their owner’s equity to determine the tax implications of their financial transactions, including investments, withdrawals, and profits or losses.
Another important way owner’s equity is important is it can be used to potentially detect financial irregularities or fraud. By comparing equity over time, it provides a snapshot of transactions that have impacted the owner’s equity balance and can help identify any unusual or suspicious activities. Looking for things like the following may help you uncover a potential problem:
- Unusual Increases in Owner’s Equity
- Inaccuracies in Capital Contributions
- Unauthorized Distributions
- Missing Transactions
- Unusual Changes to Retained Earnings
These items may not mean that there is definitely a problem, but it could be a red flag that you should investigate further. Misstating the owner’s equity can have significant consequences for the owner, and for the company overall, including:
- Legal Consequences
- Securities Fraud is a serious crime under Federal and State law, which can include criminal charges, fines, imprisonment or other penalties.
- Loss of Credibility
- Investor confidence will decrease, which may hinder raising needed capital in the future. Customers may no longer trust the business, as well, which could lead to decreased demand for products or services.
- Financial Losses
- Damage to Relationships
- Trust can be broken between a business and their stakeholders such as employees, customers, supplies and lenders.
- Loss of Competitive Advantage
All of these reasons make it extremely important to regularly review your owner’s equity to ensure your business’s financial health and stability are moving forward in the right direction. Equity is crucial to businesses since it may be used to finance expansion, in addition to growing value. Reach out to us at Knecht Business Solutions if you have any questions about your own cash flow management!