What is Owner’s Equity in Balance Sheet?

An important yet often misunderstood section of a balance sheet is the owner’s equity.  It refers to the amount invested by the owners in the company.  The term is mostly used for sole ownership and partnership business.

For registered companies that are structured as a corporation or LLC, the appropriate term is shareholder’s equity. In this blog post, you will know everything there is to know about the equity section of the balance sheet.

Owner’s Equity: What is It?

Owner’s equity refers to the rights of the owners to the business assets. The owners of a sole and partnership business can withdraw some amount from the owner’s equity.

The owner’s equity in the balance sheet is the ending balance.  The ending balance of the owner’s equity is carried forward and becomes the opening balance at the start of the next financial year.

The equity of the owner will increase when there is a profit or the owner injects additional capital into the company. In contrast, the equity of the owner decreases when the company incurs a loss or the owner draws some capital from the company.

The amount of owner’s equity for a sole proprietorship is listed as a single amount. Contrarily, Stockholders equity reported in a registered company’s balance sheet is divided into different parts including paid-up capital, stock capital, and retained earnings.

How Owner’s Equity is Calculated?

The owner’s equity is calculated using the following formula.

Owner’s Equity = Assets – Liabilities

The amount left over after subtracting net assets and liabilities is the equity of the owner.

Let’s look at an example of how owner’s equity is calculated by bookkeeping service providers.

Example 1

Let’s suppose that Mark owns a factory in Dakota. He has invested$20,000 to buy furniture and equipment and $30,000 to buy inventory. He has $30,000 cash in a business bank account. In addition, he got a loan of $30,000 to meet operational expenses. His equity in the business can be calculated as follows.

Assets = $20,000 (furniture & equipment) + $30,000 (inventory) + $30,000 (cash) = $80,000

Liabilities = $30,000 (loan)

Owner’s Equity = Asset – Liabilities = $80,000-$30,000 = $50,000

In the above example, the owner’s equity is $50,000. An important point to note is that the owner’s equity can turn negative. A negative owner’s equity means that the liabilities of the company are more than the assets

Another example will let you understand the concept of negative equity.

Example 2

Let’s suppose that Stanley owns a wholesale business in Arizona. He has invested$10,000 to buy furniture and $40,000 to buy inventory. He has $20,000 cash in a business bank account. In addition, he got a loan of $80,000 to meet operational expenses. His equity in the business can be calculated as follows.

Assets = $10,000 (furniture) + $40,000 (inventory) + $20,000 (cash) = $70,000

Liabilities = $80,000 (loan)

Owner’s Equity = Asset – Liabilities = $70,000-$80,000 = -$10,000

In the second example, the owner’s equity is negative. Negative equity in the business sheet is not always a problem. If the company’s cash inflows during the subsequent period are greater than the cash outflows, the owner equity will turn positive.

Outsourced bookkeeping services will help you save time and effort in making bookkeeping entries related to owner’s equity. Consider hiring professional accountants who have a thorough understanding of accounting-related aspects of a business.

Why Business Owners Should Focus on Owner’s Equity

Business owners need to understand owner’s equity for two purposes. It will help in maintaining an optimum capital structure. Moreover, it will help the owner in improving the liquidity position of the company.

Optimizing Capital Structure

Capital structure refers to the combination of debt and equity. The capital structure of the company is calculated by dividing debt by equity. Debt to equity ratio is an important accounting metric. It shows the stability of the company and the ability of the business to raise capital.

A high debt to equity ratio shows that the company relies too much on external financing. This will result in high financial charges for the firm. In contrast, a low debt to equity ratio shows that the company is financially stable as it has less debt as compared to equity.

Improving Liquidity Position

An understanding of owner’s equity will also help the business owner in improving the liquidity position of the company. Liquidity is the ability of a company to pay liabilities. Positive liquidity means that the company has enough assets to pay back the loans and other liabilities.

Calculating liquidity is really about determining the equity of the owner. This is because liquidity is calculated by deducting liabilities from assets. It shows whether the company has enough assets to meet financial obligations. In other words, liquidity is the dollar amount that is available for paying vendors and creditors.

So, knowing about the owner’s equity is critical to ensure that the company is operating in the green. A low or negative owner’s equity means that the company’s assets are not sufficient to meet expenses. Knowing about equity is critical to ensure that the business can sustain its operations.

The liquidity of a company will improve when the owner’s equity increases through additional revenues and gains. In contrast, the liquidity of the company will decrease due to losses or taking additional loans.

Conclusion

Owner’s equity is an important section of a company’s balance sheet. Understanding owner’s equity is important for maintaining optimal capital structure and liquidity.

The equity of the owner is calculated by subtracting all liabilities of a company from the assets of the company. Equity in the business will be positive if assets are greater than liabilities. Contrarily, the equity will be negative if liabilities will be greater than assets.

Maxim Liberty Inc offers professional bookkeeping services in the US. We focus on maintaining a relationship of utmost trust and reliability in providing bookkeeping services. Our experienced CPAs have decades of experience in maintaining accounting records in compliance with state and federal legislation. Contact us today by dialing (703) 957-6938 today.