Tucked away at the very bottom of your company’s balance sheet is a section titled “Equity.” In sole proprietorships, this section is often referred to more specifically as “Owner’s Equity.” Many business owners disregard the equity section of the balance sheet, choosing to focus instead on assets and liabilities which can seem to be easier to impact by business decisions. Owner’s equity can become an afterthought, which is unfortunate because owner’s equity gives you some very valuable information about the health of your business.
In this article, we’ll take a closer look at owner’s equity, including what it is, how to calculate it, and – perhaps most importantly – how to increase it.
Owner’s Equity Defined
Think back for a moment to the accounting equation:
Assets – Liabilities = Equity
This equation makes owner’s equity seem like a leftover…what remains after the company’s liabilities (what the company owes to others in the form of loans and accounts payable) are subtracted from its assets (what the company holds in its checking account, what is owed to the company via accounts receivable, and current and long-term assets like security deposits paid and buildings and equipment).
In accounting terms, this is exactly right: Owner’s equity is what remains after a business pays its liabilities. Instead of looking at your owner’s equity as leftovers, though, we encourage you to think of it as your stake in your business.
In other words, owner’s equity is the amount of money your business owes you. And you want this number to be as healthy as possible.
It’s important to keep in mind that owner’s equity is a term used specifically for sole proprietorships. We’ll talk more about the terms used for partnerships and corporations later in this article.
The Importance of Owner’s Equity
Owner’s equity is a good indicator of the health of your business. Although it’s not a death knell, negative owner’s equity can be a warning sign your business is in trouble.
Remember, owner’s equity is what remains after your business’s liabilities are subtracted from its assets. If your owner’s equity is negative, that indicates liabilities exceed assets. In other words, your business OWES more than it OWNS.
As much as possible, you want to avoid drawing money out of your business unless your owner’s equity is positive. Taking money out of your business when owner’s equity is already negative puts your business at increased risk of becoming insolvent. If your business is organized as anything other than a sole proprietorship, you could also open yourself up to capital gains tax by withdrawing money in excess of your business’s equity.
Don’t Confuse Equity with Value
Some business owners think owner’s equity is an indicator of the value of their business. Although potential investors, buyers, and lenders will consider owner’s equity, equity is only one component of their overall decision to invest in, buy, or lend to your business. This doesn’t mean you shouldn’t work toward a healthy owner’s equity in your business…just make sure you understand other factors will be taken into consideration when determining the value of your business.
How to Calculate Owner’s Equity
Up to this point, we’ve simplified the owner’s equity calculation. And, although the equation Assets – Liabilities = Equity is true, there is more depth to owner’s equity than this equation implies. In a sole proprietorship, owner’s equity is comprised of four different components:
- Your initial investment in the business, as well as any additional money you put into the business.
- Your draws from the business.
- Your business’s net income for the year.
- Owner’s equity from previous years. (Note: The term “retained earnings” technically only applies to corporations; however, it’s not uncommon for small business accounting software to refer to the historic owner’s equity in a sole proprietorship as retained earnings.)
Sole Proprietor's Example
Let’s say you are the sole proprietor of a coffee shop, and the following has taken place in your business:
- When you started your business two years ago, you invested $45,000 into it. This $45,000 was a mix of cash you put into the business’s checking account and things you personally purchased for the business. This investment is called “owner’s contribution.”
- Sales took a dip this year, and you had to tap your retirement account to keep the coffee shop afloat. The additional $15,000 you put into your business this year is also an owner’s contribution, but you might want to show it as a separate investment in your business’s bookkeeping for clarity.
- Over the course of the past two years, you have paid yourself $75,000 from the business. These are your draws from the business.
- For this year-to-date, the coffee shop’s net income (the “bottom line” on the Profit and Loss Statement) is negative by $23,000 (meaning you have a year-to-date loss.)
- Last year, your Net Profit was $40,000. This is your business’s retained earnings (or, more accurately for a sole proprietorship, your beginning owner’s equity balance.)
Your Owner’s Equity calculation, then, is:
$45,000 (inital investment) + $15,000 (current year investment) – $75,000 (draws) – $23,000 (year-to-date net loss) + $40,000 (last year’s net profit) = $2,000
Your stake in your coffee shop is $2,000. Notice we subtract draws from your equity. This is because draws are money you take out of the business which, in turn, reduces your stake in the business.
If you add your company’s assets and subtract its liabilities, that number should also be $2,000. If it isn’t, your balance sheet won’t balance, which indicates an error somewhere in your bookkeeping (or a bug in your accounting software.)
Statement of Owner’s Equity
You won’t see the level of detail shown above on your business’s balance sheet. The balance sheet summarizes this information instead. In order to see a detailed accounting of what comprises your owner’s equity in your business, you will need to examine another financial report called the “Statement of Owner’s Equity.”
The statement of owner’s equity for your coffee shop would look something like this:
Equity in Other Entity Types
Equity in businesses structured as partnerships or corporations (both S-corps and C-corps) works much like owner’s equity in a sole proprietorship in that the accounting equation Assets – Liabilities = Equity applies. However, there are a few differences in terminology and presentation. The two main differences to be aware of are:
- In a partnership, each partner’s equity is determined based on their individual stakes in the business, and each partner’s equity is shown separately on the balance sheet. Additionally, each partner’s equity is broken down by contributions, draws, and their portion of prior year and current year profits (or losses.)
- In a corporation, equity includes contributed capital, retained earnings, and often different types of stock. Additionally, withdrawals by shareholders are called “Shareholder Distributions” instead of draws.
There are other nuances to the breakdown of equity in partnerships and corporations and how that appears on the balance sheet, but the important thing to keep in mind is – whether a sole proprietorship, partnership, or corporation – equity refers to the owners’ stake in the business.
Increasing Owner’s Equity
Three key components determine the amount of equity you have in your business:
- The profitability of your business.
- The amount of debt your business has.
- The amount of money you take out of your business. (Note: How much you put into your business also impacts owner’s equity; but ideally, you want to avoid putting additional capital into your business. You want your business to support itself.)
You want to maximize your business’s profits and minimize the amount of debt your business has. You also want to make sure you are paying yourself (in the form of draws if you are a sole proprietor) a fair amount for the work you do in your business. And, it would also be nice to have a business that performs so well you can give yourself an additional profit distribution on a regular basis.
Doing this takes some planning, but you don’t need to have a business degree to achieve a healthy and ever-increasing owner’s equity. Implementing a cash management system like the Profit First methodology helps you keep your business’s expenses in check, which in turn increases your profitability. The Profit First system also ensures you pay yourself well, but not in excess of what your business can healthily support. Finally, Profit First forces cash savings in your business, which ensures your business’s assets remain robust while you eradicate any business debt.
The Bottom Line on Owner’s Equity
Owner’s equity is the last thing on your business’s balance sheet, but it’s one of the most important indicators of your business’s overall health. Even though other elements go into calculating the value of your business, a healthy owner’s equity will increase the confidence of investors, buyers, and lenders, which can help you get more favorable terms in your negotiations.
If your owner’s equity is low or negative, work with your accountant or bookkeeper to strategize ways to improve it. You might also consider implementing a system like Profit First to help you get your business’s expenses in check without having to spend hours poring over budget spreadsheets.
With a little attention and care, you can build a healthy owner’s equity in your business, giving you peace of mind that your business can continue to support itself AND you.