In principle, firms in private industry exist to build owner wealth. They create value for owners (owners equity) by earning profits and directing these funds into Retained Earnings.
Owners equity is the ownership interest of shareholders in the assets of a company. Owners equity represents what the owners own outright.
Business textbooks often describe the highest level objective for a profit-making company as "Increasing owner value." In this sense, Owners equity, therefore, represents the company's reason for being.
Owners Equity and the Balance Sheet Equation.
Owners equity is one of three main sections of the Balance Sheet. And, for that reason, it also appears in the so-called Accounting Equation, or Balance Sheet Equation.
Assets = Liabilities + Owners equity
Owners equity = Assets– Liabilities
= Net Worth
The Balance sheet always "balances," whether the firm's financial position is excellent, or terrible. The balance holds because double-entry principles and accrual accounting ensure that every change to one side brings an equal, offsetting change on the other side.
Assets are items of value the firm owns or controls, acquired at a measurable cost, which the firm uses for earning revenues. Balance Sheet Assets, therefore, represent the book value of everything the firm has to work with to bring income. Note especially that the first equation shows clearly that the firm's assets are partly owned by owners (as Equity) and partly owned by creditors (as Liabilities).
The second equation above shows clearly that Owners equity is the part of the asset value left after subtracting the firm's liabilities. What remains is what the shareholder owners own. The second equation also helps explain another name for Owners equity, namely the firm's Net Worth.
Book Value vs. Owners Equity and Related Terms
"Owners equity" goes by many names. The term is essentially synonymous with all of the following:
One other term, book value appears, above, referring to the value of the firm's assets. When referring to the value of the firm itself, however, some people equate the firm's book valuewith Owners equity. Strictly speaking, the firm's book value represents the asset value that remains if the firm goes out of business, now. For that purpose, a firm's the "book value" definition is:
Book Value = Owners equity
– Preferred stock – Intangible assets (e.g., goodwill)
Explaining Owners Equity in Context
Sections below further define and describe Owners equityin context with related concepts, emphasizing four themes:
- First, the definition and meaning of Owners Equity, equity sources, and equity reporting on the balance sheet.
- Second, Owners Equity role when companies declare bankruptcy or liquidate.
- Third, Owners Equity role in creating financial leverage, and two quities metrics: Total-Debt-to-Equities and Long-Term Debt-to-Equities.
- Fourth, strategies for increasing Owners Equity and causes of equity decrease.
- What is Owners equity (net worth)?
- What is the source of Owners equity?
- When is the Owners equity concept essential?
- What is the role of Owners equity in creating financial leverage?
- How do companies increase or decrease Owners equity (net worth)?
- Balance sheet example with Owners equity Net worth.
- Example Statement of retained earnings.
- See the article Capital and Financial Structures for more on the role of Equities and Liabilities in creating leverage.
- See Balance Sheet for an overview of Balance Sheet structure, content, and usage.
- The article Trial Balance explains the transfer of net income to Balance Sheet Retained Earnings and Owners Equity.
Firms create Owners equity primarily from two sources: Firstly, from "contributed capital," and secondly, from "retained earnings." Exhibit 1, below shows how funds from these two sources appear on the Balance sheet as two sections under Owners equity.
This capital consists of funds investors pay for the purchase of stock directly from the company issuing the shares. This payment occurs at the company's initial public offering (IPO), and when the company reissues more shares, later. Note, however, that stock shares bought in the secondary market do not add to contributed capital. When investors buy shares in the secondary market (the "Stock Market") buyer's purchase funds, of course, go to the seller.
These funds are profits the company earns and uses to grow equity. The other primary use for earnings that a company may choose (besides adding them to retained earnings) is to distribute them directly to shareholders as dividends.
See the section Increasing and Decreasing Owners equity, below, for more on these components.
The Owners equity concept applies to companies in business, but it is similar to the notion in personal finance, where a homeowner speaks of "equity" in a home property. In that case, Equity represents the initial down payment on the property plus the part of the mortgage loan principal that has been "paid off."
In the Exhibit 4 Balance Sheet example, below, for instance, the firm reports Balance Sheet assets of $22,075,000 and liabilities of $8,938,000. As a result, Owners equity is the difference between these two numbers, $13,137,000. The relationship between Liabilities, Assets, and Owners equity becomes especially important to owners and investors in at least two situations:
- When the company goes out of business and into liquidation
- When the company chooses a capital structure including a degree of financial leverage
What is the Role of Owners equity in Liquidation?
A firmhat goes out of business may choose to liquidate. As a result, the firm sells (liquidates) its assets and uses the proceeds as follows:
- Firstly, to pay off outstanding liabilities and creditors, including bondholders.
- Secondly, to pay taxes and liquidation expenses, including legal fees and judgments.
- Thirdly and finally, any remaining funds go to others with an "equity claim." Those may include owners of preferred shares, owners of common stock shares, and even the company's managers, employees and pension holders in some cases.
The precise order of preference and the rules for distributing the remaining funds to these groups may be specified at different times and in different ways. The company may write liquidation rules and priorities in its original articles of incorporation. Or, it may spell out new or additional rules when creating and issuing shares of stock. In any case, firms may or may not include provisions for paying dividends due to shareholders.
Those whose claims come last in the order of precedence for receiving payment on equity claims are said to have a residual claim.Not surprisingly,this term usually applies to owners of common stock shares.
In Liquidation, Liabilities Claims Prevail Over Shareholder Claims
With the above process in view, it is understandable why the company's creditors and shareholders alike have a very keen interest in the relative magnitudes of the company's liabilities compared to owners equities.
- Shareholders may fear that the liability claims may consume all or most of the funds raised through liquidation, leaving little or nothing for them.
- At the same time, if liabilities are large relative to Owners equity, creditors may fear that proceeds from asset liquidation will not even be large enough to pay off all creditors.
Investors and potential investors should note that actual funds from the sale of the company's assets in liquidation may be either substantially more or substantially less than the Balance Sheet book value for these assets. Asset book values are not necessarily the same or even close to assets actual market value or realizable value.
Companies May Declare Bankruptcy but Still Intend to Stay in Business
Also, investors and potential investors should remember that in most countries a company may declare bankruptcy while intending to stay in business. In such cases, the company does not liquidate. Instead, it reorganizes, while doing the following:
- Receiving legal protection from creditors
- Re-negotiating or discarding labor contracts, and other agreements
- Perhaps selling off parts of the business
In this kind of bankruptcy, the fate of existing shareholder value and shareholder equity claims is much less prescribed and much less sure. In the United States, this kind of bankruptcy process is a Chapter 11 bankruptcy filing (referring to its Chapter in the United States Bankruptcy Code).
Risks of a business enterprise are borne both by creditors and owners, in proportion to their share of the company's funding. The relative magnitudes of creditor supplied funds (Balance Sheet Liabilities) compared to investor provided funds (Owners equity) is the firm's level of financial leverage.
Potential Leverage Benefits
In a healthy economy or when the business is otherwise doing well, owners may make more on creditor supplied funds than they pay for the cost of borrowing. In a healthy economy or when the business is otherwise doing well, owners may make more on creditor supplied funds than they pay for the cost of borrowing. This gain is the primary benefit of using leverage.
Potential Leverage Risks
However, the reverse can be true in a weak economy or if the company is performing poorly for other reasons: in those cases, earnings may not be high enough to justify the cost of funding (interest payments on the borrowed funds). In that case, borrowing costs fall especially heavily upon the owners, illustrating one of the risks of using leverage.
Risks and Rewards of High Leverage
When creditors provide the majority of a company's funding (compared to financing provided by owners), the company is said to be highly leveraged.
- If a highly leveraged company fails and defaults on loans, creditors will lose much more than owners.
- When business is good for a highly leveraged company, it should be able to service its debt. And, in this case, shareholders can look forward to relatively large gains on their relatively small investments. Benefits will go to owners either as dividends or as retained earnings, which increase Owners equity.
Several financial leverage metrics compare the funds supplied to a company by creditors to the funds provided by owners. Two of the most commonly used leverage metrics appear here: Firstly, the total deb-to-equities ratio, and secondly, the long-term debt-to-equities ratio. For more on leverage and leverage metrics, see the article leverage.
Leverage Metric 1: Total Debt-to-Equities Ratio
The first of these ratios, total debt to stockholders' equities, is the strongest of these measures. That means it provides the most conservative view of creditor protection. This ratio compares two Balance sheet entries, Total Liabilities, and Total Owners Equity.Figures for this example appear in the sample Balance Sheet below in Exhibit 4:
Liabilities total: $8,938,000
Stockholders equities total: $13,137,000
Total debt-to-equities ratio
= Total liabilities / Total stockholders equities
= $8,938,000 / $13,137,000
Leverage Metric 2: Long-Term Debt-to-Equities Ratio
Another debt-to-equities ratio, long-term debt to stockholders equities, is less conservative than the previous ratio. It is, however, more properly a measure of leverage because the debt figure contains only debt to lenders or long-term debt. By contrast, the "Total debt" figure for the previous metric includes debt to vendors, employees, and tax authorities as well as debt to lenders.
Using figures from the Balance Sheet example in Exhibit 4 below:
Long-term liabilities: $5,474,000
Stockholder's equities: $13,137,000
Total debt-to-equities ratio
= Total long-term liabilities / Total stockholders equities
= $5,474,000 / $13,137,000
Rules of Thumb for Debt-to-Equities Ratios
The average "debt-to-equities" ratios vary widely between industries, and between companies within industries. Even so, there are some general "rules of thumb" for evaluating a company's ratios:
- Potential lenders will compare a company's debt-to-equities ratios to industry standards. Consequently, If the company's ratios are quite different from industry standards, lenders will need extra assurance that the departure from standards does not represent increased risk—especially debt service risk.
- Potential Investors will also consider carefully the sources of existing debt as well as the firm's prospects for repayment. Thus, potential investors will weigh the risks associated with existing individual liabilities, such as varying loan service costs with different loans. And, they will view these costs as an important factor in addition to the debt to equity ratios themselves.
- With the above in mind, potential lenders generally consider a total debt-to-equities ratio of 0.40 or lower as "good," and a long-term debt-to-equities ratio of 0.30 or lower as good. As the company's debt-to-equities ratios increase above these values, firms have more trouble acquiring new loans.
Further Coverage on Leverage
For more in-depth coverage of leverage metrics, with examples, see the article Leverage Metrics. For quantitative examples of business benefits and risks that go with leverage, see the article Capital and Financial structure.
Many businesspeople regard Owners equity as a company's reason for being. Owners equity, after all, represents the often-stated highest-level objective for companies in private industry: Increase owner value. There are only a few ways that firms can increase or decrease Owners equity.
Increasing Owners Equity Through Contributed Capital
Contributed capital (or Paid-in-capital) is a Balance sheet equity account, showing what stockholders have invested by purchasing stock from the company. Exhibits 2 and 4, show clearly where contributed capital appears on the Balance sheet. When investors buy shares directly from the company, that is, the company receives and keeps the funds as contributed capital. When investors buy shares on the open market, however, funds go to the investor selling them.
Contributed capital is one of the two principal Owners equity categories on the Balance sheet. The other is "Retained earnings." Contributed capital, in turn, has two main components:
- Stated capital.
Stated capital is usually the "stated" or par value of the stock shares issued. For Exhibit 4, below, "stated capital" is the sum of values for "Preferred stock" and "Common stock."
- Additional paid-in capital.
These funds are also known as Capital contributed in "excess" of par. They represent funds the company receives that exceed part value.
Contributed capital in both categories can thus flow company and add to Owners equity at the company's initial public stock offering (IPO). And, it will add again, later, when the firm issues more stock shares. (For more on the difference between par value and capital contributed more than par, see the article par value).
Increasing Owners Equity through Retained Earnings
Contributed capital does add to Owners equity. However, company owners will expect management to add to Owners equity primarily by earning profits and then using them to grow retained earnings.
For purposes of financial accounting, a profit making company can do only two things with profit earned:
- Firstly, distribute to shareholder owners as dividends.
- Secondly, keep some or all of the profits as retained earnings. Many companies divide earnings for both uses each year.
Each reporting period, firms publish the "disposition of earnings" (income) for the period. They report the "disposition of earnings" on the company's Statement of Retained Earnings, one of the four primary financial accounting reports published quarterly and annually by publicly held companies. The other three are the Income Statement, Balance Sheet, and Statement of Changes in Financial Position SCFP.
The statement shows how profits from the period (from the Income Statement) are either transferred to the Balance Sheet, as retained earnings, or to stockholders as dividends. As a result, the Statement of Retained Earnings serves as a bridge between the Income Statement and Balance Sheet.
The Retained Earnings Equation
The Statement of Retained Earnings equation is as follows:
= Preferred stock dividends payments
+ Common stock dividends payments
+ Retained earnings
This equation solves for Retained earnings as follows:
= Net income
– Preferred stock dividends payments
– Common stock dividends payments
Retained earnings, in other words, are the funds remaining from net income after paying dividends to shareholder owners. Each period's retained earnings are added to the cumulative total from previous periods, to create the current retained earnings balance.
In the Exhibit 2 Statement of Retained Earnings above, retained earnings at the end of the previous reporting period and the beginning of the present period stand at $2,660,000. This figure comes from the last year's Balance Sheet. For the period just ended, however, the company reports Net income of $2,172,000. If the company pays no dividends, the new retained earnings total will be the sum of these two figures, $4,832,000. In this case, however, the company does elect to pay dividends totaling $1,134,000. That leaves retained earnings now at $3,698,000.
The company has, in other words, increased owner value this period both by paying dividends and by growing retained earnings (thus adding to Owners equity). Note that this example refers to cashdividends. Companies may also issue stock dividends to shareholders. In that case, Owners equity decreases but paid in capital increases by an equal amount. Thus, the payment of stock dividends has no overall impact on Owners equity.
Decreasing Owners Equity.
In small, privately held companies it is not unusual for owners to withdraw funds from the company from time to time. For this, they use a withdrawal account takes funds directly from an Owners equity account. Such an account is an Equity "contra account," sometimes called a "drawing account." Withdrawals through this account reduce Owners equity, of course. Such withdrawals and reductions to Owners equity are much rarer in public companies with large numbers of shareholders.
The more usual means of reducing Owners equity is the payment of expenses. In fact, the general definition of "expense" refers to its impact on Owners equity: In accounting, an expense is a decrease in Owners equity from using up assets in producing revenue or carrying out other business activities.
Owners equity is one of three main sections of the Balance Sheet, as Exhibit 3, below shows. Note, however, that some firms identify Owners equity as Stockholder's Equity for the Balance Sheet.