By Mark Henricks
Owner’s equity is the value of a business that the owner can claim, and it consists of the firm’s total assets minus its total liabilities. Both the amount of owner’s equity and how much it has changed from one accounting period to another offer insights into a business’s financial condition. This term is used with sole proprietors and partnerships. Learn what comprises this important element in a firm’s balance sheet and how to calculate the metric.
The statement of owner’s equity is one of the four basic financial statements of a business. The other three are income statement, balance sheet and statement of cash flows. The term “owner’s equity” is used with sole proprietors and partnerships. An equivalent term, “shareholder’s equity,” is used with corporations. “Book value” is another term used interchangeably with shareholder’s equity in a corporation’s balance sheet.Components of Owner’s Equity
One component of owner’s equity is the firm’s assets. This includes money, property, any inventory and capital goods. It also includes any additional funds the owner has added to the company since startup, either from net income or fresh capital from additional owners. Greater investment by the owner, all things being equal, means more owner’s equity.
A second element in owner’s equity is its liabilities. This includes money taken out of the business to pay wages and salaries as well as paying down debts. Sometimes owner’s equity is called a residual claim on company assets since liabilities have a higher claim than the owner’s claims.
Owner’s equity also includes retained earnings. These are profits that are reinvested in the company rather than being distributed to the owner or owners as dividends or used to pay down debt. Retained earnings can grow to become a large part of owner’s equity over time.Owner’s Equity Formula
The simplest way to calculate owner’s equity is to subtract liabilities from assets. The result is the owner’s equity in the business. The formula is:
Assets – Liabilities = Owner’s Equity
Assets will include the inventory, equipment, property, equipment and capital goods owned by the business, as well as retained earnings, which may be in the form of cash in a bank account. Accounts receivable owed to the business by customers will also be included as assets. On a typical balance sheet, assets will be listed on the left side.
Liabilities will include bank loans and other debts, wages and salaries owed to employees, unpaid rent and utilities. Balance sheets generally list liabilities in a column on the right side.
Owner’s equity also shows on the right-hand sign of the balance sheet. While owner’s equity is an asset to the owner, to the business it represents a potential claim, so is listed on the same side as liabilities.
As an example, consider an auto repair shop with assets that include a building worth $500,000, equipment worth $250,000, inventory worth $50,000, retained earnings of $25,000 in a bank account and accounts receivable valued at $30,000. Adding all these up produces assets of $855,000.
Assets = $500,000 + $250,000 + $50,000 + $25,000 + $30,000 = $855,000
On the liability side, the building has a mortgage of $350,000, owes $100,000 to equipment vendors and suppliers, and $100,000 in unpaid wages and salaries. This comes to $550,000.
Liabilities = $350,000 + 100,000 + $100,000 = $550,000.
Using the formula to subtract liabilities form assets shows that the owner’s equity in this auto repair business is $305,000.
Owner’s equity = $855,000 – $550,000 = $305,000Factors Affecting Owner’s Equity
Owner’s equity can increase if revenues and profits increase and profits are retained, that is, reinvested in the business.
If the company loses money, on the other hand, owner’s equity will be reduced. Owner’s equity can also be decreased by the amount of the “draw” the owner takes as compensation. However, if the owner or owners inject more money into the business, known as paid-in capital, it can offset or minimize a reduction in owner’s equity from a loss or draw.
Knowing the owner’s equity or shareholder’s equity is essential for calculating a firm’s debt-to-equity ratio. Knowing how leveraged or indebted a business is can be an indication of how how solid a company’s financial condition is. Keep in mind, though, depending on the industry and where the company is in its life cycle, a high level of debt may not necessarily be a bad thing.The Bottom Line
Owner’s equity represents the value of a business that could be claimed by the owner if the business were liquidated. It is calculated by subtracting liabilities from assets. Owner’s equity can be used to evaluate a business’s performance and prospects. Increases in owner’s equity from one year to the next may indicate a business is well-managed and succeeding. Decreases in owner’s equity may indicate the owner needs to inject more capital into the company.Tips for Investing
Photo credit: ©iStock.com/sturti, ©iStock.com/GCShutter, ©iStock.com/Totojang
Information contained on this page is provided by an independent third-party content provider. Frankly and this Site make no warranties or representations in connection therewith. If you are affiliated with this page and would like it removed please contact firstname.lastname@example.org