Owner’s EquityDefined with Examples & How to Calculate

If you frequent this site or any other sites that have accounting and finance write-ups, you’re probably already familiar with the basic accounting equation.  

Just to recap, the basic accounting equation states that a business’s total assets must equal the sum of its total liabilities and equity.

You can simply write it as “Assets = Liabilities + Equity”.

As can be seen from the basic accounting equation, there are three components to it: assets, liabilities, and equity.

Of the three, equity is probably the least talked about.

It’s not given as much attention as assets and liabilities.

It gets this rapport because it is often seen as the residual figure after deducting total liabilities from total assets.

But the truth is, equity is just as important as the other two (being assets and liabilities).

There’s more to equity than just that.

Equity represents the amount of capital that the owner has invested in the business.

It can also represent the amount of profit that the business has accumulated over the years.

Lastly, it represents the amount that the owner will receive should the business liquidate (or stop operating).

Basically, equity represents the owner’s financial interest in the business.

So yeah, it’s more than just a figure you get after subtracting liabilities from assets.

We’ll be learning more about equity (a.k.a. owner’s equity) in this article.

We will define it, as well as identify the things that cause it to increase or decrease.

By the end of the article, you should have a better understanding and appreciation of what the owner’s equity is.

Without further ado, let’s get right to it!

 

What is Owner’s Equity?

If you search around the web, you’ll often find owner’s equity to be described as the residual amount after subtracting liabilities from assets.

While this description isn’t wrong, it doesn’t give owner’s equity justice. 

As such, here’s a better description: owner’s equity represents the owner’s financial interest in the business.

Essentially, it’s the owner’s right to the business’s assets.

At the start of the business’s existence, the owner’s equity will solely represent the amount invested by the owner in the business.

As the business continues operating, it will either generate profits or losses (ideally, you want your business to generate profits).

When the business generates profits, it also means that the owner’s initial investment grows as profits mean returns for the owner.

On the other hand, when the business generates losses, the owner’s equity will decrease.

This is because, on top of failing to generate profits, losses also mean that the business “consumed” the owner’s investment without providing returns.

So to summarize the previous point, profits increase owner’s equity while losses decrease it.

Another way to increase a business’s owner’s equity is for the owner to make an additional investment.

When an owner makes an additional investment, s/he increases the stake s/he holds in the business.

On the other hand, drawings or withdrawals of investment decrease the owner’s equity.

This is because drawings mean that the owner is taking away some of her/his investment in the business.

In the case that the business liquidates or discontinues its operations, the owner’s equity will represent the amount that the owner will receive.

The term “owner’s equity” is mainly used for sole proprietorships.

This is because a sole proprietorship only has one owner.

In an LLC or corporate setting where the are multiple owners, owner’s equity is referred to as “shareholders’ equity” instead.

What’s Included in Owner’s Equity?

As the business grows and continues its operations, the owner’s equity will accumulate items on top of the owner’s initial investment.

The following is a list of items that increase the owner’s equity:

• The initial investment of the owner in the business (during the creation of the business); this could be in the form of cash and/or any other asset (e.g. building, machinery, equipment)
• Additional investments that the owner makes towards the business; again, these could be in the form of cash and/or other assets
• Profits that the business generates

And here’s a list of items that decrease the owner’s equity:

• Drawings or money/capital that the owner takes away from the business
• Losses that the business incurs

In addition, the owner’s equity can be negative if the business has more liabilities than assets.

This can also happen if the drawings exceed the owner’s equity.

For example, if the business has an owner’s equity of $20,000 and the owner draws $30,000 out of it, the business will have a negative owner’s equity of $10,000 after the drawing.

In a corporate setting, equity will include other items such as the following:

• Share Capital (Common Shares, Preferred Shares)
• Treasury Stock (contra-equity account)
• Additional Paid-in Capital (payments exceeding the par value of shares)
• Retained Earnings (the portion of net profits reinvested in the business)

Can Owner’s Equity be Negative?

The short answer: yes, owner’s equity can be negative.

The long answer: when a business’s liabilities exceed its assets, it causes a deficit.

This is when the owner’s equity becomes negative.

In such a case, the owner may have to inject additional capital into the business just to cover the deficit.

Otherwise, the business will continue to operate with negative equity in its financial statements.

This can be a major turn-off for potential creditors.

When the owner’s equity is negative, the owner should refrain from making any drawings.

This is because when the owner takes draws from the business when it has negative equity, those draws can be taxable as capital gains for the owner.

This is because the owner is gaining money/capital at the business’s expense.

Besides, the business cannot afford to have more capital taken away from it.

Ideally, the owner should only make drawings if the business has a positive owner’s equity.

Furthermore, the drawings should not exceed the balance of the business’s owner’s equity.

Owner’s Equity: is it an Asset?

Technically, owner’s equity is an asset… for the owner that is.

But for the business itself, it isn’t an asset.

This is because the owner owns it, not the business.

Just think of owner’s equity as what the business owes to its owner.

Assets are properties that the business owns and/or controls.

They often provide economic benefits to the business.

For example, cash allows a business to pay for the business’s expenses and liabilities.

Fixed assets such as buildings, machinery, and equipment facilitate business operations that eventually lead to the generation of revenue (and ideally, profits).

Inventory includes goods that the business will eventually sell for profit.

On the other hand, the owner’s equity represents the owner’s stake in the business.

So rather than an asset, it is more akin to liability from the business’s point of view.

It represents the amount that the owner can claim after the business pays for all of its liabilities.

Additionally, assets typically have a debit balance. On the other hand, the owner’s equity typically has a credit balance. S

o no, the owner’s equity is not the business’s asset.

Calculating Owner’s Equity

You can calculate a business’s owner’s equity in two ways.

Let’s start with the simpler one.

It’s derived from the basic accounting equation “Assets = Liabilities + Equity”.

Instead of using the “default” form, we derive the Equity figure by rearranging the formula as follows:

Equity = Assets – Liabilities

This must be why equity has the reputation of being the residual amount after subtracting the business’s liabilities from its assets.

It’s simple as you only need two figures: the total assets, and the total liabilities.

Let’s take a look at the following balance sheet and see if we can compute the owner’s equity:

From the illustration above, we gather following information:

• Total assets = $76,870.00
• Total liabilities = $51,870.00

With the above information, we can proceed with the computation of equity:

Equity = Assets – Liabilities

= $76,870 – $51,870

= $25,000

As per computation, the business has an owner’s equity of $25,000.

With this figure, we can complete the balance sheet of PL Santos:

The other way to compute owner’s equity is a more direct method. It follows the formula:

Owner’s Equity = Owner’s Initial Investment + Additional Investments + Profits – Drawings Made by the Owner – Losses

While not entirely complicated, it provides more challenge as it needs more information than the other method.

 Simply put, anything that increases owner’s equity is added, while those that decrease it are subtracted.

For example, let’s say we have the following information:

• Mario made an initial investment of $50,000 for his sole proprietorship
• As of date, Mario made total additional investments of $30,000
• The business has continually produced profits since its inception; as of date, it made $43,000 total profits
• Total drawings made by Mario amounted to $25,000

Using the information above, we can compute for the business’s owner’s equity:

Owner’s Equity = Owner’s Initial Investment + Additional Investments + Profits – Drawings Made by the Owner – Losses

= $50,000 + $30,000 + $43,000 – $25,000 – $0

= $98,000

As per computation, Mario’s sole proprietorship has an owner’s equity of $98,000.

Conclusion

Owner’s equity is more than just a figure.

It’s more than just what you get after subtracting liabilities from assets.

It has actual value.

More importantly, it represents the owner’s stake in the business.

Without it, the owner wouldn’t know how much his/her initial investment has grown since the inception of the business.