As a small business owner, you are in a unique 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, known as "equity" works?
What Is Equity and Owner's Equity?
The term "equity" means something of value or worth. It can also mean ownership. Generally, when looking at equity you want to consider the value of something and how much you owe is on that value. What's left over is equity.
Owner's equity is an owner's ownership in the business, that is, the value of the business assets owned by the business owner. It's the amount the owner has invested in the business minus any money the owner has taken out of the company.
Only sole proprietor businesses use the term "owner's equity," because there is only one owner.
Owner's Equity = Total Business Assets – Total Business Liabilities
It's the same as the general accounting formula (Assets = Liabilities – Owner's Equity), in a different order.
How Owner's Equity Works
Owner's equity changes based on different activities of the business. It increases with (a) increases in owner capital contributions, or (b) increases in profits of the business. 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 takes money out of their owner's equity, the withdrawal is considered a capital gain, and the owner must pay capital gains tax on the amount taken out.
An example: Equity in real estate means the part of the value of a 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, then the equity is $20,000.
Start with a new business in which an original owner investment as beginning owner's equity, to see how it changes over time:
- Plus donated assets by the owner (equipment or a vehicle, for example)
- Minus distributions to the owner (amounts the owner takes out of the business)
- + Profits of the business
- – Losses of the business
Owner's Equity on a Balance Sheet
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 are liabilities (what's owed by the business) and owner's equity (what's left).
Owner's equity changes over time. It's included on the business balance sheet at the end of an accounting period — month, quarter, or year.
What Is an Equity Interest?
An equity interest is an ownership interest in a business entity, from the concept of equity as ownership. Shareholders have equity interest as their purchase of shares of stock in the corporation gives them a share in the ownership of the business. Equity interest is in contrast to creditor interest from loans made by creditors to the business.
Tom begins a business and puts in $1,000 from his personal checking account and a laptop computer valued at $1,000. This $2,000 amount is a capital contribution since Tom has contributed capital in the form of cash and property to the business.
The next month, Tom takes a $500 draw from the business. So his net owner's equity is $1,500 at the end of the second month. If the owner takes more money out of the business than he put in, or the business has continuing losses and no profits, it results in negative owner's equity.
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.
- Owners' Equity shows the business owner's share in the value of a business
- The owners' equity equation is Owners Equity = Assets - Liabilities
- It decreases when the owner takes money out or when the business has a loss
- It increases when the owner makes a capital contribution or when the business has a profit