The proportion of the total value of a company’s assets that can be claimed by the owners and shareholders
Written byCFI Team
What is Owner’s Equity?
Owner’s Equity is defined as the proportion of the total value of a company’s assets that can be claimed by its owners (sole proprietorship or partnership) and by its shareholders (if it is a corporation). It is calculated by deducting all liabilities from the total value of an asset (Equity = Assets – Liabilities).
The liabilities represent the amount owed by the owner to lenders, creditors, investors, and other individuals or institutions who contributed to the purchase of the asset. The only difference between owner’s equity and shareholder’s equity is whether the business is tightly held (Owner’s) or widely held (Shareholder’s).
In simple terms, owner’s equity is defined as the amount of money invested by the owner in the business minus any money takenout by the owner of the business. For example: If a real estate project is valued at $500,000 and the loan amount due is $400,000, the amount of owner’s equity, in this case, is $100,000.
How to Calculate Owner’s Equity
Owner’s equity can be calculated by summing all the business assets (property, plant and equipment, inventory, retained earnings, and capital goods) and deducting all the liabilities (debts, wages, and salaries, loans, creditors).
Example: Computer Assembly Warehouse
Let’s assume that Jake owns and runs a computer assembly plant in Hawaii and he wants to know his equity in the business. Jake’s balance sheet for the previous year shows that the warehouse premises are valued at $1 million, the factory equipment is valued at $1 million, inventory is valued at $800,000 and that debtors owe the business $400,000. The balance sheet also indicates that Jake owes the bank $500,000, creditors $800,000 and the wages and salaries stand at $800,000.
Therefore, owner’s equity can be calculated as follows:
Owner’s equity = Assets – Liabilities
Where:
Assets = $1,000,000 + $1,000,000 + $800,000 + $400,000 = $3.2 million
Liabilities = $500,000 + $800,000 + $800,000 = $2.1 million
Jake’s Equity = $3.2 million – $2.1 million = $1.1 million
Therefore, the value of Jake’s worth in the company is $1.1 million.
How Owner’s Equity Gets Into and Out of a Business
The value of the owner’s equity is increased when the owner or owners (in the case of a partnership) increase the amount of their capital contribution. Also, higher profits through increased sales or decreased expenses increase the amount of owner’s equity.
The owner can lower the amount of equity by making withdrawals. The withdrawals are considered capital gains, and the owner must pay capital gains tax depending on the amount withdrawn. Another way of lowering owner’s equity is by taking a loan to purchase an asset for the business, which is recorded as a liability on the balance sheet.
The value of owner’s equity may be positive or negative. A negative owner’s equity occurs when the value of liabilities exceeds the value of assets. Some of the reasons that may cause the amount of equity to change include a shift in the value of assets vis-a-vis the value of liabilities, share repurchase, and asset depreciation.
How Owner’s Equity is Shown on a Balance Sheet
The owner’s equity is recorded on the balance sheet at the end of the accounting period of the business. It is obtained by deducting the total liabilities from the total assets.
The assets are shown on the left side, while the liabilities and owner’s equity are shown on the right side of the balance sheet. The owner’s equity is always indicated as a net amount because the owner(s) has contributed capital to the business, but at the same time, has made some withdrawals.
For a sole proprietorship or partnership, the value of equity is indicated as the owner’s or the partners’ capital account on the balance sheet. The balance sheet also indicates the amount of money taken out as withdrawals by the owner or partners during that accounting period.
Apart from the balance sheet, businesses also maintain a capital account that shows the net amount of equity from the owner/partner’s investments.
Shareholder’s equity refers to the amount of equity that is held by the shareholders of a company, and it is sometimes referred to as the book value of a company. It is calculated by deducting the total liabilities of a company from the value of the total assets.
Shareholder’s equity is one of the financial metrics that analysts use to measure the financial health of a company and determine a firm’s valuation.
Shareholder’s Equity = Owner’s Equity (they’re the same thing).
The following are the main components of Owner’s equity:
1. Retained earnings
The amount of money transferred to the balance sheet as retained earnings rather than paying it out as dividends is included in the value of the shareholder’s equity. The retained earnings, net of income from operations and other activities, represent the returns on the shareholder’s equity that are reinvested back into the company instead of distributing it as dividends.
The amount of the retained earnings grows over time as the company reinvests a portion of its income, and it may form the largest component of shareholder’s equity for companies that have existed for a long time.
2. Outstanding shares
Outstanding shares refers to the amount of stock that had been sold to investors but have not been repurchased by the company. The number of outstanding shares is taken into account when assessing the value of shareholder’s equity.
3. Treasury stock
Treasury stock refers to the number of stocks that have been repurchased from the shareholders and investors by the company. The amount of treasury stock is deducted from the company’s total equity to get the number of shares that are available to investors.
4. Additional paid-in capital
The additional paid-in capital refers to the amount of money that shareholders have paid to acquire stock above the stated par value of the stock. It is calculated by getting the difference between the par value of common stock and the par value of preferred stock, the selling price, and the number of newly sold shares.
Related Readings
Thank you for reading CFI’s guide to Owner’s Equity. To keep learning and advancing your career, the following resources will be helpful:
