In simple terms, the definition of owners’ equity can be stated as “A part of the total value of a company’s assets which is claimable by the owners (in case of sole proprietorship and partnership firm) and by the shareholders (in the case of a company)”. However, in the latter case, it is better known as stockholders’ equity or shareholders equity.
Numerous accounting equations can be used to define the term in a better way. Here are some of them:
(1) Owner’s Equity = Assets – Liabilities
This is the most common equation used for understanding the meaning of owner’s equity. It is the value obtained by subtracting the liabilities that the owner owes to lenders, creditors, investors and other sets of individuals from the total assets of the company.
(2) Owner’s Equity = Available Capital + Retained Earnings
In this equation, owner’s equity is defined as the sum total of business capital and the earnings retained after paying all the liabilities. Let’s take an example in which the capital available to a company at the beginning of a new financial year is $500,000. Now suppose that the owner contributes additional $30,000 to the capital. And the company’s net income (retained earnings) by the end of the year is $70,000. At the end of the financial year,
Owner’s Equity = $500,000 + $30,000 + $70,000 = $600,000
Suppose that the owner withdraws $20,000 for his personal use during the year. The result would be,
Owner’s Equity = $600,000 – $20,000 = $580,000
So, what is owner’s equity finally?
Owner’s Equity = Equity (Previous Year Balance) + Capital Added During the Year+ Retained Earnings + Present Year Net Profit -Withdrawals
For stockholders’ equity/owner’s equity, withdrawals could be the dividends that are distributed in case of a company or personal drawings done by proprietor/partners in case of a firm.
Owner’s equity is also referred at times as book value of the company as it comes from two main sources, the first being “investment is done in business in the form of capital” and the second being “profits that accumulate in the business”. It represents the current stake held on the business by equity investors of the business.
It is worth mentioning that owner’s equity may at times be negative. A negative value generally represents the bad business position of the company, while yearly increasing positive value represents a healthy financial state of business supported by business growth.
Owner’s Equity Vs. Net Worth
In general, owner’s equity and net worth refer to the same value. However, finance or accounting experts should understand the comparison of owner’s equity with net worth. The difference lies in the use of these terms in personal and business perspectives. While owner’s equity is strictly a business accounting term, net worth can also be referred to the owner’s personal value which may include business equity as well as home equity, investments, bank accounts, valuable items like jewellery and other collections.
Generally, increasing owner’s equity year by year indicates the better business position (except in a case where an addition to capital is more than accumulated profits during a period compared). Moreover, it helps in keeping the companies in the good books of bankers, lenders, investors and other associates.