From a financial perspective, equity is a great thing. In its simplest form, equity helps quantify the value of something. So what is owner’s equity? It’s a special brand of equity that applies to business owners.
First, let’s step back and look at equity in a broader sense. You often hear about equity in regard to homeownership. For example, your brother-in-law might boastfully tell you at Thanksgiving dinner that he has $415,000 in equity in his home. Because your brother-in-law isn’t known for always being as informed as he ought to be, let’s look at the formula you could use to get the truth.
Assets – Liabilities = Equity
First, you’d ask your brother-in-law how much his home is worth. He replies that his home appraised at $630,000. The next question is how big the mortgage is. Your brother-in-law tells you that he only owes $315,000 on the home. Going back to the equity formula, the home value is the asset here and the remaining mortgage is the liability. The resulting number is the equity.
630,000 – $315,000 = $315,000
Turns out your brother-in-law was exaggerating once again. Given the home’s value and the remaining mortgage, his equity is substantially less than the $415,000 that he announced to you earlier.
Despite the reckless way people like your brother-in-law might handle the numbers, equity is extremely important. This is why you must pay close attention to the owner’s equity on your small business’s financial statement.
Owner’s equity is simply a business version of the home equity your brother-in-law was so vocal about. It reveals how big of a stake you have in your business’s assets. The formula for owner’s equity mirrors the version shared earlier:
Business Assets – Business Liabilities = Owner’s Equity
If your business has $500,000 in assets and $250,000 in liabilities, your owner’s equity sits at a cool $250,000. To increase that amount, you’d need to either build up your business’s assets, decrease its liabilities, or a combination of both.
Common examples of assets reflected in owner’s equity include things like money you’ve invested in the business and the profits your business has brought in. Depending on the way you’ve structured your company, it might also include common stock, preferred stock, treasury stock, and retained earnings.
On the flip side, there are plenty of liabilities that count against an owner’s equity. The most common examples are the various financial obligations your business compiles through its operations.
The reason that owner’s equity is displayed in its own section on the balance sheet, rather than in the assets section, is because the business doesn’t benefit from the owner’s equity. The owner does. If all the assets listed on the balance sheet were sold and all the financial obligations squared away, the owner would then claim the remaining equity.
Remember to always keep an eye on the owner’s equity on your financial statements. It provides a concise view of where your business value stands.