Owner’s equity is one of the three components of the accounting equation so understanding its basics is a key step for beginners who are learning accountancy.
In this post, I give a simple explanation of the owner’s equity, its various components, how you can calculate it, and how different types of accounting transactions affect it. Once you’ve figured out the basics of owner’s equity, be sure to solve the free quiz at the end to test your understanding!
Definition of Owner's Equity
Owner’s equity is the value of assets left in a business after subtracting the amount of its liabilities. For example, if the total assets of a business are worth $50,000 and its liabilities are $20,000, the owner’s equity in that business is $30,000, which is the difference between the two amounts.
Owner’s Equity is also known as Net Assets, Net Worth, Shareholder’s Equity, and Owner’s Capital.
Most businesses use at least some debt to finance their operations, whether it’s a loan from a bank or a credit from the supplier.
However, because creditors have a legal preference over business owners in receiving payments, the owners need to know how much of the total assets of a business exceed its debt.
If we add up all assets in a business and subtract any amount borrowed from creditors, we are left with the owner’s equity. In theory, this is the amount that the business owners can take home if a business is shut down immediately and all of its liabilities are paid in full.
So you can think of owner’s equity as the net worth of a business to its owners resulting from their capital investment and business profits.
How is Owner's Equity Calculated?
As you might have guessed, we find owner’s equity by adding up all assets in a business and subtracting the total liabilities as shown in the formula below:
Owner’s Equity = Total Assets – Total Liabilities.
Here’s a worked example of owner’s equity calculation. The calculation itself is very straightforward so try to work out your own solution to the question below before seeing the suggested solution!
Example
A laundromat has the following assets and liabilities on 31 December 2020:
Assets
- Equipment $20,000
- Furniture $5,000
- Fixtures $10,000
- Receivables $3000
- Cash $7,000
- Supplies $5,000
Liabilities
- Loan from bank $25,000
- Rent payable $3,000
- Electricity bill payable $2000
What is the owner’s equity in this business on 31 December 2020?
Total Assets = $20,000 + $5,000 + $10,000 + $3,000 + $7,000 + $5,000 = $50,000.
Total Liabilities = $25,000 + $3,000 + $2,000 = $30,000.
Owner’s Equity = Total Assets – Total Liabilities = $50,000 – $30,000 = $20,000.
What Does Owner's Equity Include?
The balance sheet shows the composition of the owner’s equity.
Depending on the legal and accounting framework of a business, the owner’s equity can include:
- Surplus capital contributions from the owners such as the paid-up share capital of a company after subtracting any return of capital to them in the form of owner withdrawals, shares buyback, etc.;
- Retained earnings that have been reinvested in the business and not distributed to the owners in the form of dividends or profit share;
- Any other equity reserves such as the capital reserve;
- Gains and losses recorded in the other comprehensive income.
How does Owner's Equity Change?
Here’s how the different types of accounting transactions and balances affect the value of owner’s equity in a business.
| What increases the owner's equity | What reduces the owner's equity |
|---|---|
Capital contributions by owners | Withdrawals by owners (e.g., dividend payouts) |
Income / Gains / Profits | Expenses / Losses |
Retained Earnings | Accumulated Deficit |
It is important to keep in mind, though, that many accounting transactions don’t impact the owner’s equity.
These can include transactions that replace one asset with another. For example, if a business purchases a machine for cash, it only changes the composition of the assets. The net assets (owner’s equity) in this case will remain the same.
Another example is when a business borrows money. It creates an asset on one side of the equation and an equal liability on the other side. Because the increase in liability offsets the increase in assets, the net assets (owner’s equity) remains the same as before.
Can Owner's Equity Be Negative?
Owner’s equity is normally a credit balance on the balance sheet which basically suggests that the total assets exceed the total liabilities of a business. This is expected when a business has been profitable for many years.
However, if a business piles up considerable losses instead of profits, its assets may not cover the full amount of its liabilities, i.e., negative owner’s equity.
Negative owner’s equity means that a business’s liabilities exceed the value of its assets which is a sign of severe financial distress.
Quiz
How much do you know about Owner's Equity?
Question 1
+
Incorrect.
_
Spot on!
Question 2
Which of the following transactions reduce the owner’s equity?
A
Correct!
Withdrawals by owners reduce their equity in a business.
B
Wrong answer.
This should actually increase the owner's equity.
C
Incorrect.
The repayment of a business loan from a business bank account does not affect the owner's equity because it reduces the total assets and total liabilities leaving the equity unchanged.
Question 3
Which of the following transactions have no effect on the owner’s equity?
A
Incorrect.
This is a capital contribution to a business that should increase the owner's equity.
B
You're right!
The overall effect of the loan and equipment purchase is to increase the total liabilities and assets by the same amount.
It does not however impact the owner's equity in the business.
C
Incorrect.
Expenses reduce the owner's equity in a business.
Question 4
What is the value of owner’s equity?
$240,000
Incorrect.
$220,000
Incorrect.
$200,000
Correct!
Total Assets = $100k + $20k + $40k + $60k = $220k.
Total Liabilities = $15k + 5k = $20k.
Owner's Equity = $220k - $20k = $200k.
How many questions did you answer correctly?
Score Grade
4 Master
3 Pass
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