Owners' equity definition
/What is Owners’ Equity?
Owners’ equity is the capital theoretically available for distribution to the owner of a sole proprietorship. It is generally considered to be the total assets of an entity, minus its total liabilities. From a company liquidation perspective, owners' equity can be considered the residual claim on the assets of a business to which shareholders are entitled, after liabilities have been paid. Since the liquidation value of assets may be quite low, this can mean that the owners’ equity in a business is actually zero.
How to Calculate Owners’ Equity
Owners’ equity can be calculated by extracting a number of items from a firm’s financial statements. In the balance sheet of a sole proprietorship, owners' equity refers to the sum total of the following transactions:
+ Original owner investment in the business
+ Donated capital
+ Subsequent profits of the business
- Subsequent losses of the business
- Subsequent distributions to the owner
= Owners' equity
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Owners’ Equity vs. Business Fair Value
The amount of owners' equity does not necessarily represent the fair value of a business, so the sale of a business in the exact amount of owners' equity would be purely coincidental. In reality, the sale price could be substantially different, depending on the perceived value of the company's cash flows, intellectual property, branding, and other factors as determined by the acquirer and agreed to by the acquiree. Also, if a business must be sold on short notice (perhaps due to its impending bankruptcy), then the reduced number of bidders will generally reduce the price at which the business can be sold.
What is Included in Owners’ Equity?
The following classifications of financial activities are included in owners’ equity:
Invested funds. This is the amount that owners invest in the business. It increases owners’ equity.
Retained earnings. This is the cumulative amount of earnings generated by the business over its lifetime. It increases owners’ equity.
Owner withdrawals. This is any money taken from the business by the owners. It reduces owners’ equity.
Business losses. These are losses incurred by the business. It reduces owners’ equity.
How to Increase Owners’ Equity
The only ways to increase the amount of owners' equity are to either convince investors to invest more funds in the business, or to increase profits. A concern with the first option is that an influx of new investors will water down the original owners’ interests in the business, possibly to the point where they no longer have control over the business. Increasing profits will require either an expansion of revenues (for which new products or services may need to be developed) or tighter control over expenses, or a combination of the two.
Terms Similar to Owners’ Equity
Owners' equity is known as shareholders' equity if the legal entity of a business is a corporation. It is also known as net worth, net assets, or shareholders' funds.