How to Calculate Equity
In small business accounting, you calculate your company's equity by deducting your total liabilities from your total assets. Hence, equity is the portion of the total value of a company's assets that you, as the owner, can claim. In essence, it refers to your company's net worth.
You can have a positive or a negative owner's equity. Negative ownership equity means total debts outweigh the value of the assets. That's why it's crucial to understand how equity is calculated and what it means. It offers insight into the value of the company and gives a clear picture of what the business is worth.
Read on to learn more about owner's equity, how it's calculated, and what's included in the calculation.
What Is Equity?
Equity is the net value of a business. That's why it's referred to as the company's book value, net worth, or net assets. It's also called owner's equity or shareholders' equity because it represents ownership in a company.
Your owner's equity is the amount you invested in your business. For businesses structured as corporations, shareholders' or stockholders' equity refers to the amount distributed to shareholders if they liquidate all the company's assets and pay all the liabilities. The equity section of a corporation's financial statement may also include common stock, preferred stock, share capital, capital surplus, stock options, retained earnings, and treasury stock.
You'll find the owner's equity account in the company's balance sheet. It's generally recorded at book value, which means it only includes tangible assets. A company may have intangible assets, such as a recognizable brand name, reputation, and goodwill, that may raise its value. However, this value may only be recognized when a business is sold or acquired by another company.
Classes of Equity
For corporations that issue stocks, there are two classes of ownership:
- Common stocks. Common stocks, also called common shares, are units of ownership, giving the shareholder the right to earn dividends and control over the direction of a business. Common stock owners may vote to appoint officers of the company, elect board members, and participate in determining policies. However, in the case of company liquidation, common stockholders are only entitled to any residual equity after bondholders, preferred shareholders, and other creditors are paid in full.
- Preferred stock. Preferred stocks are securities that represent ownership in a company. Stockholders of this class of equity have no voting rights and carry fewer responsibilities in the company's governance. However, preferred shareholders receive dividend payments before common stockholders, and they have a greater claim to assets over common shareholders if the company goes bankrupt and its assets are liquidated.
Where Does Stockholders' Equity Come From?
When you start a business, your initial capital makes up your owner's equity. As your operations expand and you reinvest profits into your company, your equity grows, as well. The same is true for corporations and public companies, except they operate on a larger scale. Below are terms used for the sources of stockholders' equity:
- Capital stock. Capital stock refers to cash or cash equivalents contributed by investors in exchange for ownership shares of common stock or preferred stock.
- Additional paid-in capital. When investors pay for shares above the stated par value or share price, the difference is recorded in a paid-in capital equity account. This type of equity account is also referred to as a contributed surplus or paid-in surplus. The balance increases or decreases as the company experiences gains and losses from selling shares.
- Retained earnings. Retained earnings refer to the portion of the corporation's net income reinvested into the company. When a corporation earns revenue from operations and other activities, the profits are usually divided into retained earnings, dividend payouts to shareholders, or used to repurchase the company's stocks. For companies that have been operational for a long time, the retained earnings account may represent the largest amount of shareholders' equity.
Another component of stockholders' equity is the treasury stock account. The treasury stock records the amount paid by the company to repurchase its stocks from investors. The account has a negative balance, which means it reduces the total shareholders' equity.
In stock buybacks, companies do it to reinvest in their own business, improve their financial ratios, or reduce dilution caused by employee stock option plans. Dilution happens when a company issues new shares that decrease the existing stockholders' ownership percentage.
When the company's repurchased shares are absorbed, the number of outstanding shares on the market is reduced. The result is fewer shares on the market, and the ownership percentage of each investor increases. That's why buybacks benefit shareholders because they always increase the stock's value in the short term. However, the corporation's success and growth still depend on how the company is managed.
How Do You Calculate Your Company's Equity?
You can calculate your company's equity using the accounting equation: Equity = Total Assets − Total Liabilities. You can pull the assets and liabilities from the balance sheet. From there, you can calculate the equity value by deducting the total liabilities from the total assets.
Skynova's accounting software can help you track your owner's equity and get a clearer sense of the factors that contribute to your company's overall net worth. For example, if you are launching a new product or service, you can observe changes in equity by generating financial statements through the software. From there, keep tabs on increases or decreases to the company's liabilities, revenues, and assets.
What Are Assets?
Assets are anything of value that your business owns. You buy or produce assets to generate income. The balance sheet reports how your company's assets are financed: either through debt or equity.
On the balance sheet, asset accounts are listed in order of their liquidity — how easily they can be converted into cash. They are also divided into current assets and non-current or long-term assets. Current assets can be converted to cash within one year or the company's operating cycle. Meanwhile, non-current assets include long-term investments, fixed assets, and intangible assets.
Examples of business assets include:
- Cash and cash equivalents
- Accounts receivable
- Office furniture and equipment
- Land and buildings
- Stocks, bonds, and securities
- Intellectual properties (trademarks, patents, etc.)
To calculate your total assets, add up all the amounts from each item. Remember to deduct any depreciation or amortization for fixed assets and intellectual properties, such as patents.
What Are Liabilities?
Liabilities are debts and obligations that your business owes to outside parties. Examples include office rent, salaries and wages, invoices from suppliers, and bills from utility companies. Liabilities are also classified into current and long-term debts.
Current liabilities include payables due now and within one year. Company expenses, such as salaries, office supplies, and rent, fall under this category. Long-term liabilities are debts that have due dates beyond one year (e.g., mortgages and vehicle loans or leases).
Why Is Understanding Shareholders' Equity Important?
Understanding shareholders' equity is important because it's a useful metric to learn about the financial health of a business. Financial analysts use stockholders' equity with the company's financial statements to determine a firm's valuation. Generally, a higher stockholders' equity means the company has stable finances, which allows for flexibility in the case of an economic decline or recession.
Let Skynova Help You Manage Your Small Business Equity
Your business equity measures the relationship between your company's assets and liabilities. Track your owner's equity with Skynova's accounting software. Generate financial statements, such as balance sheets, income statements, and cash flow statements, whenever you need them.
Calculate your equity from current and reliable information. This gives you a real insight into the value and ongoing profitability of your business. Knowing where your business stands helps you make better-informed decisions in running and growing your business.
Notice to the Reader
The content within this article is meant to be used as general guidelines and may not apply to your specific situation. Always consult with a professional for specific and individual accounting advice.