In previous posts, we brought the balance sheet into focus and then adjusted our aperture to focus on three important balance sheet analyses. Now we’ll take a closer look at one of the main sections of the balance sheet – Owner’s Equity.
Think of owner’s equity in terms of a time-lapse.
A time-lapse is a technique of taking a sequence of photos at set intervals to record changes that take place slowly over time. Much like a time-lapse, owner’s equity contains a record of all the financial activity that has taken place in your business since the inception of the business.
(For ease of understanding, we’ll just use the term owner’s equity in this post. Owner’s equity is the term used in a sole proprietorship. Partnership equity is the term used for a partnership. Shareholders or stockholders equity are terms used for LLCs and other types of corporations.)
To begin our discussion of owner’s equity, let’s first review the basic accounting equation.
Assets = Liabilities + Owner’s Equity
Remember, these are the three main sections of the balance sheet.
Now, let’s rearrange the equation to get Owner’s Equity by itself:
Owner’s Equity = Assets – Liabilities
This shows clearly that owner’s equity is the owner’s rights to the assets of the business after subtracting what’s owed.
Calculating Owner’s Equity
We can also arrive at the amount of owner’s equity by examining how money flows into and out of a business.
- Add: Owner’s personal money invested in the business during a specified time period.
- Add/Subtract: Profits/losses of the business since the beginning; also called Retained Earnings. Retained Earnings is the amount of money that you have paid tax on, but have not withdrawn from the business.
- Subtract: Money taken out of the business by the owner during a specified time period; also called draws.
Compare your equity over several time periods to look for trends.
Keep tabs on whether owner’s equity is increasing or deceasing. Just as you’d like to see your personal net worth increase, you also want your owner’s equity to increase over time. Your business will be in a much stronger position to weather unforeseen circumstances (like a pandemic!) if you have enough equity in your business.
Ways to Increase Owner’s Equity
- Increase owner contributions
- Decrease owner draws
- Increase business profits by:
- increasing sales
- decreasing expenses
In times when your business is not as profitable, your equity will not increase as rapidly, or it may even start to decrease if you start to have significant net losses. Seeing a trend of decreasing owner’s equity month after month or quarter after quarter may be a red flag that your business is floundering.
Typically, not having enough equity means that you’re short on cash. If you don’t have the cash in your business to satisfy your liabilities, you’ll need to either procure a loan or put in more of your personal money to cover the shortage. For many people, there’s a limit to the amount they can infuse into their business from their personal piggy bank.
So how can we oversee owner’s equity to keep a business on solid footing for the long-term?
Manage Owner’s Equity
- Keep the equity in your business for the first several years, if at all possible.
- Pay yourself a wage, instead of taking owner draws of random amounts at random times.
- If your business is a sole proprietorship, setup a sub account of owner’s equity to differentiate it from the profits/losses of the business.
- If your business is a corporation, have your wage come out as a payroll expense instead of as a draw. We realize that it’s not fun to see a decrease in net income. However, the problem with pulling money from equity instead of adjusting net income is that it artificially makes your net income inflated. This gives the illusion that the business is doing better than it actually is. In the long-term, drawing a wage will actually present a clearer picture of how your business has actually performed.
- Maintain enough capital reserves.
- Having cash/liquid assets for 3 months of average monthly expenses is great, but 6 months worth is even better. During difficult financial times, this will give you peace of mind to be able to avoid dipping into your personal money or taking on additional debt.
Owner’s equity is one of the most commonly ignored sections of the balance sheet. Yet you can see how vital it is to look after it and take steps to protect it. While you will likely capture a few undesirable frames due to the obstacles in life, we hope that the time-lapse of your business shows overall growth.
If we can assist you in seeing a clearer picture of your financial statements, let us know. We’re happy to help!