Learn About Owner's Equity
Owner's Equity on a Business Balance Sheet
As a small business owner, you are in a special circumstance of ownership. You own everything in the business except what you owe to other people. That's great, but do you really know how this ownership (called "equity") works? This article explains the concept of owner's equity and why it's important for you to know about it.
Equity and Owner's Equity
The term "equity" means value or worth. It can also mean ownership. In a general way of looking at equity, consider the value of something and how much is owed on that value. What's left over is equity. For example, equity in real estate means the part of the value of a piece of property that's not the loan amount. So, if a property is valued or appraised at $100,000, and the loan amount—the current principal—is $80,000, the equity is $20,000.
Owner's equity is an owner's ownership (equity) in the business, that is, the amount of the business assets owned by the business owner. Another way to look at this concept is to say that owner's equity in a business is the amount the owner has invested in the business minus any money the owner has taken out of the business in the form of a draw—not as salary.
You can find the amount of owner's equity in a business by looking at the balance sheet. On the left are assets, the value of what the business owns. On the right at the top are liabilities, what's owed by the business, and the owner's equity: what's left over. See below for a more complete explanation of the balance sheet.
An equity interest is an ownership interest in a business entity, from the concept of equity as ownership. Shareholders have equity interest; their purchase of shares of stock in the corporation gives them a share of the ownership of the business. Equity interest is in contrast to creditor interest from loans made by creditors to the business.
How Owner's Equity Grows
Owner's equity is increased by (a) increases in owner capital contributions, or (b) increases in profits of the business. This is oversimplified, but basically, the only way an owner's equity/ownership can grow is by investing more money in the business, or by increasing profits through increased sales and decreased expenses. If a business owner withdraws money from owner's equity, the withdrawal is considered a capital gain and the owner must pay capital gains tax on the withdrawal.
Business Ownership and Capital Accounts
Each owner of a business has a separate account called a "capital account" showing his or her ownership in the business. The value of all the capital accounts of all the owners is the total owner's equity in the business.
For example, let's say Tom begins a business and puts in $1,000 from his personal checking account and a computer valued at $1,000. This $2,000 amount is called a capital contribution since Tom has contributed capital in the form of cash and property to the business.
The next month, Tom takes a draw from the business in the amount of $500. So his net owner's equity is $1,500 at the end of the second month. Having a net negative owner's equity if the owner takes more money out of the business than was contributed.
How Owner's Equity Is Shown on a Business Balance Sheet
Owner's equity changes over time, and it is shown at the end of an accounting period—month, quarter, or year—on the business balance sheet. The calculation of owner's equity is assets minus liabilities. In a simplified example, if the value of the business assets is $3.5 million and the total business liabilities are $2.5 million, the owner's equity is $1 million. As mentioned earlier, the business balance sheet shows assets on the left and liabilities and owner's equity on the right.
On the balance sheet, owner's equity is shown as a net amount at a specific moment in time, usually the end of a month, quarter, or year. The net amount results from the owner contributing to and taking money out of the business. Owner's equity is expressed differently in each type of business: