Most startup and small business owners tend to focus most of their time and efforts on understanding assets and liabilities while not considering “equity” as an equally critical aspect of running a business. This guide will offer you an in-depth explanation of what “owner’s equity” is, its importance in the business world, and how it is calculated.
Generally speaking, owner’s equity refers to the owner’s rights to the remaining finances and assets after all liabilities and obligations are paid or accounted for. The owners equity can alter with time, as a result of various ongoing business activities. It can increase or decrease, which can lead to a situation where liabilities are more than assets, or vice versa.
According to Investopedia, “Equity represents the amount of money that would be returned to a company’s shareholders if all the assets are liquidated and all of the company’s debt was paid off in the case of liquidation.”
The owner’s equity can surge following an increase in the capital the owner contributes to the business. Usually, a consistent rise in owners equity is a sign of a healthy business concern, given that the rise is due to higher profitability and not the owner putting more money into the business to keep it afloat.
An owner’s equity grows over time either by injecting more capital into the business or through cutting down on expenses and increasing profits. Similarly, the owner’s equity also decreases if the liabilities of a business become greater than its assets. This is what is known as a “negative owner’s equity.”
An example can help in understanding owner’s equity better. Suppose John, a sole trader, decides to open a brewery. He invests $5,000 into his business and makes a profit of $2,000 during the first financial year. John also withdraws $4,000 from his business. Thus, the owners equity in this example for John would be his investment added to the profit with the subtraction of any liabilities. In this scenario, that is the amount withdrawn, which brings John’s total equity to $21,000.
The rule of thumb for calculating owner’s equity is that assets and liabilities should be inversely proportional to one another.
Since we know now what owner’s equity is, how it increases and diminishes, it is important to understand its significance and how it helps a business owner make smarter financial choices.
Owner’s equity is an important concept and helps corporate owners become aware of the claim they have on their business assets and the overall financial standing. This ties in closely into the capital structure of a business, which refers to the way a company finances the assets it owns under its equity and debt. So capital structure refers to your financial claim and standing over the assets of a business.
As a business grows, the liabilities increase, which by extension means that more parties have claimed over the assets now. Let’s say I put $100 into a company, and now the total liabilities of the said business are around $70. That leaves around $30; now whatever these liabilities may be – whether it’s bank loans, bills, etc., $30 is what’s left after all liabilities have been subtracted from the assets. These liabilities have more of a claim or financial standing than I would as the business owner. The amount left after my liabilities have been accounted for would constitute my owner’s equity.
Shareholder’s equity is an important metric in determining the return being generated versus the total amount invested by equity investors.
This helps businesses be more confident when making decisions regarding expansion, future investments, increasing value, and more.
Investors tend to stay away from a business with negative equity, especially if this negative equity has become a long-standing feature of the business. This is called ‘Balance Sheet Insolvency’.
It is important to note that owner’s equity is not the only indicator of a company’s financial standing; other factors such as cash flows, intangible factors such as the company’s customer base and brand, are valid indicators, too.
However, if used in conjunction with other tools, owner’s equity helps analyze the current state and financial health of a business. A real-world example of the utility of shareholder’s equity is present in the 2014-2016 fall of equity of PepsiCo Inc. Pepsi is a leading figure in the soda industry, and their equity fell from $17.4 billion to $11.1 billion.
From the eyes of an investor, a sharp fall in owner’s equity-like this would raise doubts about whether or not investing in Pepsi is a reasonable choice. This could also be taken further by comparing their owner’s equity to that of a rival company like Coca-Cola, which is Pepsi’s primary competition.
Their total shareholder equity fell from $30.3 billion to $23.01 billion. While this may seem like a worse fall than that of Pepsi, the actual percentage of the drop isn’t as significant with Coca-Cola, which suggests that the soda giant successfully handled its debts.
As an investor, this proves to be a more promising investment opportunity. Investors are more likely to lean towards a company that has a handle on their liabilities and shows a steady rise in their owner’s equity. Another advantage of owner’s equity is that the owner can draw on it for any expense, however, this should be done sparingly.
Now that we have firmly established an understanding of what owner’s equity is, how it rises and falls, the practical usages of it, you will now learn how to measure owner’s equity. The accounting equation that helps in understanding it better is as follows:
Shareholder’s equity = Total Assets – Total Liabilities
The owner’s equity is placed in the business’s balance sheet at the end of its respective accounting period. However, it is not shown as an asset on the company’s balance sheet, because the owner’s equity is an asset of the business owner, not the business itself.
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