One of the most important (and underrated) lines in your financial statements is owner’s equity.
Here’s everything you need to know about owner’s equity for your business.
What is owner’s equity?
Owner’s equity is essentially the owner’s rights to the assets of the business. It’s what’s left over for the owner after you’ve subtracted all the liabilities from the assets.
If you look at your company’s balance sheet, it follows a basic accounting equation:
Assets – Liabilities = Owner’s Equity
The term “owner’s equity” is typically used for a sole proprietorship. It may also be known as shareholder’s equity or stockholder’s equity if the business is structured as an LLC or a corporation.
What’s included in owner’s equity?
Owner’s equity includes:
- Money invested by the owner of the business
- Plus profits of the business since its inception
- Minus money taken out of the business by the owner
- Minus money owed to others
If the business is structured as a corporation, equity may also include accounts like:
- Retained earnings
- Common stock
- Preferred stock
- Treasury stock
- Additional paid-in capital
Is owner’s equity an asset?
Business owners may think of owner’s equity as an asset, but it’s not shown as an asset on the balance sheet of the company. Why? Because technically owner’s equity is an asset of the business owner—not the business itself.
Business assets are items of value owned by the company. Owner’s equity is more like a liability to the business. It represents the owner’s claims to what would be leftover if the business sold all of its assets and paid off its debts.
Can owner’s equity be negative?
Owner’s equity can be negative if the business’s liabilities are greater than its assets. In this case, the owner may need to invest additional money to cover the shortfall.
When a company has negative owner’s equity and the owner takes draws from the company, those draws may be taxable as capital gains on the owner’s tax return. For that reason, business owners should monitor their capital accounts and try not to take money from the company unless their capital account has a positive balance.
How to calculate owner’s equity
Owner’s equity is calculated by adding up all of the business assets and deducting all of its liabilities.
For example, let’s look at a fictional company, Rodney’s Restaurant Supply. It’s Rodney’s first year in business, and he had the following transactions:
Rodney invested $20,000 in the company to rent a location, purchase initial inventory, and pay other startup costs
Rodney got additional funding from an SBA loan
In his first year in business, Rodney’s Restaurant Supply’s income statement shows net income of $150,000 after accounting for all revenues and business expenses
Rodney took $75,000 in draws from the business
On December 31, here’s the balance sheet of Rodney’s Restaurant Supply:
If you look at the balance sheet, you can see that the total owner’s equity is $95,000. That includes the $20,000 Rodney initially invested in the business, the $75,000 he took out of the company, and the $150,000 of profits from this year’s operations.
It’s also the total assets of $117,500 minus total liabilities of $22,500. Either way you calculate it, Rodney’s state in the business is $95,000.
It’s important to note that owner’s equity is not necessarily a reflection of the actual value of the business. If Rodney wanted to sell the company, the sales price of the business would vary depending on other factors, including:
- The value of the company’s cash flows
- The fair market value of the company’s fixed assets and inventory
- The value of the company’s revenue stream
- Intangibles such as brand recognition and the customer list
The book value of owner’s equity might be one of the factors that go into calculating the market value of a business. But don’t look to owner’s equity to give you a complete picture of your company’s market value.
What is a statement of owner’s equity?
Some financial statements include a statement of owner’s equity. This financial statement provides details about the changes to the owner’s capital account over a certain period, such as:
- The opening balance of the owner’s capital account
- Increases to equity from profits or additional capital contributions
- Decreases to equity from losses or capital distributions
- The closing balance of the owner’s capital account
The closing balances on the statement of owner’s equity should match the equity accounts shown on the company’s balance sheet for that accounting period.
For example, the statement of owner’s equity for Rodney’s Restaurant Supply would look like this:
Generally, increasing owner’s equity from year to year indicates a business is successful. Just make sure that the increase is due to profitability rather than owner contributions keeping the business afloat.