Looking for information about what owner’s equity is, how to calculate it and why it’s important to a business? We have an explanation for all of the components here!
Owner’s Equity Defined
The definition of owner’s equity is the residual equity that remains after deducting liabilities from the assets of a business. Owner’s equity represents the claims by the owners and stockholders of a business to the capital available for distribution to the shareholders and is sometimes referred to as equity, net assets, net worth, owner’s capital or book value.
Owner’s and stockholder’s equity are basically what would be left over after a business sold all of its assets and paid off all of its debts.
Also see: What is an equity injection?
What Is The Owner’s Equity Formula?
Now that we know what an owner’s equity account is, how do we calculate it? The owner’s equity formula or basic accounting equation is simply: Owner’s Equity = Assets – Liabilities
So as an example of equity accounts, if the assets of a business are worth $100,000, and there is business debt in the amount of $25,000, then owner’s equity will be $75,000.
The value of owner’s equity is not necessarily a reflection of the true value of the business as it is reported at the time of the transaction. Additionally, the sales price of a business will vary depending on the purchaser’s value of the company’s cash flows, intellectual property and many other factors.
In accounting, you will likely hear about the accounting equation or balance sheet equation which a variation of this formula:
- OE = Total Assets – Total Liabilities,
- Assets = Liabilities + OE
- Liabilities = Assets – OE
Why Is Knowing Owner’s Equity Important?
Knowing the amount of equity a business has at year end as well as the previous year is important when trying to obtain a business loan or investment. A business that as equity will be in a better position to get an expansion loan from a lender.
Also knowing the equity of a business provides an owner a price for the business that is likely the liquidation value.
Where Do You Find The Value Of Owner’s Equity?
The owner’s equity accounting equation is Owner’s Equity = Assets – Liabilities.
What Increases Owner’s Equity?
Owner’s equity can increase through an increase in retained earnings (profits) or from an investment in the company from the owner or outside investor.
The equation shows that an increase in assets will also increase owner’s equity. Assets can increase from an increase in accounts receivable, which typically results from an increase in sales. Assets can also increase from purchasing new equipment. Purchasing equipment may not increase owner’s equity if that equipment was financed since the increased assets are offset by the increase in debt.
Where Do You Find Owner’s Equity?
Owner’s equity is found on the balance sheet, which is one of the three primary financial statements with the income statement and cash flow statement. Balance sheets are a financial statement that is a snapshot in time and is shown as a net amount at a specific accounting period, like at the end of a month, quarter, or year. A business can also prepare a statement of owner’s equity.
To calculate owner’s equity, subtract assets from liabilities. As an example, say the assets of a business are $500,000 and the business liabilities are $100,000. Subtracting assets from liabilities, owner’s equity is $400,000.
Owner’s equity is shown differently between sole proprietorships, partnerships and corporations. In a sole proprietorship or partnership, owner’s equity is shown as the owner’s or partner’s capital account on the balance sheet. In a corporation instead of calling it owner’s equity, it is instead called retained earnings.
What Is The Relationship Between Net Income And Owner’s Equity?
Net income is the amount of a companies revenues that are left over after paying all expenses are just one factor that can affect the equity of a business. When a company makes a profit and keeps some of that profit, the business’s assets increase which increases owner’s equity. If a business’s profits were to decline, owner’s equity will decrease as well.
Accounts That Affect Owner’s Equity
|Revenue||Owner’s equity increases when revenue increases and is retained|
|Expense||Owner’s equity decreases when spending cash for expenses|
|Withdrawal||Owner’s equity (usually cash) taken out of a business for the owner’s personal use|
|Cash and Supplies||Owner’s equity decreases when paying cash for supplies|
|Cash and Prepaid Insurance||Owner’s equity decreases when paying cash for insurance|
|Supplies and a Liability Account||Owner’s equity decreases when buying supplies on account|
|Cash and a Liability Account||Owner’s equity decreases when paying cash towards a liability (debt)|
|Cash and Capital (Revenue Account)||Owner’s equity increases when receiving cash from sales|
|Cash and Capital (Expense Account)||Owner’s equity decreases when paying cash for an operational expense|
|Dividends||Owner’s equity decrease when dividends are paid|