Equity: Owner's Equity, Net Worth, and Book Value

Definitions, Meaning, and Examples

Owners equity is the book value of company assets owned outright by shareholders. On the balance sheet, owners equity includes contributed capital and retained earnings. Increasing owner value is often cited as the highest level objective for profit-making companies

Owner's equity (or owners equity, or stockholder's equity, net worth, or book value of a company) is the ownership interest of shareholders in the assets of a corporation. Owner's equity, that is, 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, owner's equity represents a company's reason for being. 

Owner's equity is one of the three main sections of the so-called accounting equation, or balance sheet equation. When companies publish a balance sheet after a reporting period ends, the following equality must hold:

Assets = Liabilities + Owner's equity

The total Balance Sheet Assets value represents the "book value" of everything the company has to work with, for earning money. Owner's equity is the portion of that value that the owners (shareholders) presently own. If owner's equity is subtracted from Asset value, the remainder represents Liabilities, monies owed by the company to lenders, bond holders, and other creditors. 

Owner's equity, in turn has two components: Contributed capital + Retained earnings. As shown in the balance Sheet example below, these components are:

• Contributed capital, which includes funds paid by investors for the purchase of stock directly from the company. This occurs at the company's initial public offering (IPO), and when the company issues more shares again at subsequent stock offerings (Stock shares purchased in the secondary market do not contribute to contributed capital). See the encyclopedia entry on contributed capital for more on the components of this category.
• Retained earnings are profits the company has earned and used to grow equity. The other main use for profits that a company may choose (instead of adding them to retained earnings) is to distribute profits directly to shareholders as dividends.

See the section Increasing and Decreasing owner's equity, below, for more on these components.

The owner's equity concept applies to companies in business, but the idea is comparable to the idea in personal finance, where a homeowner speaks of "equity" in the 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."

Contents

• The importance of owner's equity (Net worth)
   - Owner's equity in liquidation
   - Owner's equity in financial leverage
      - Total debt to equities ratio
      - Long term debt to equities ratio
      - Rules of thumb for debt to equities ratios
• Increasing or decreasing owner's equity (Net worth)
   - Increasing owner's equity through contributed capital
   - Increasing owner's equity through retained earnings
   - Decreasing owner's equity   
• Balance Sheet example with owner's equity (Net worth)
• Example statement of retained earnings 

The importance of owner's equity (Net worth)

In the Balance Sheet example below, for instance, a company's Balance Sheet assets are reported as $22,075,000 and its liabilities as $8,938,000, while owner's equity is the difference between these two numbers, $13,137,000.

The relationship between Liabilities, Assets, and owner's equity (Net Worth, Book Value of the Company) becomes especially important to owners and potential investors in at least two situations.

1. When the company goes out of business and into liquidation.
2. When the company chooses a capital structure including a degree of financial leverage.

Owner's equity in liquidation

When a company decides to go out of business and goes into liquidation, its assets are sold (liquidated) and the proceeds are used first to pay off outstanding liabilities and creditors (including bondholders), and to pay taxes and liquidation expenses (including legal fees and legal judgements). Only then can any remaining funds be distributed to others with an "equity claim."  

Those remaining with an equity claim 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 ahead of time in several different ways and 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 (this designation usually applies to owners of common stock shares).

The order and rules for equity distribution under liquidation may be spelled out when stock shares are created and first issued, and/or in the original company articles of incorporation.

With the above process in view, it is understandable why the company's creditors and the company's shareholders 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 owner's 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 raised through 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. Balance sheet book value for assets is not necessarily the same or even close to assets actual market value or realizable value.

Also, investors and potential investors should remember that in most countries a company may declare bankruptcy, but not intend to go out of business. In such cases, the company does not liquidate, but instead "reorganizes" while receiving legal protection from its creditors, re-negotiating or discarding labor contracts and other contracts, and 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 certain.  In the United States, this kind of bankruptcy process is known as a Chapter 11 bankruptcy filing (referring to its Chapter in the United States Bankruptcy Code). 

Owner's equity and financial leverage

Risks of a corporate 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 (included in Balance Sheet Liabilities) compared to investor supplied funds (owner's equity) is called financial leverage.

In a strong 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, illustrating a benefit of using leverage. However, the reverse can be true in a poor economy or if the company starts 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), and the borrowing costs fall especially heavily upon the owners, illustrating one of the risks of using leverage.

When the majority of a company's funding is provided by creditors (compared to funding 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 owners (shareholders) can look forward to relatively large gains on their relatively small investments. Gains will go to owners either as dividends or as retained earnings, which increase owner's equity.

Several financial leverage metrics compare the funds supplied to a company by creditors to the funds supplied by the company's owners. Two of the most commonly used leverage metrics are shown here: (1) The total debt to equities ratio, and (2) the long term debt to equities ratio. For more coverage of leverage and leverage metrics, see the encyclopedia entry leverage.

The leverage metrics examples here use data from the sample Balance Sheet, also included below.

     Total debt to equities ratio

The first of these debt to equity ratios, total debt to stockholders' equities, is the strongest of these measures, that is, it provides the most conservative view of creditor protection. This ratio compares two Balance Sheet entries, Total Liabilities and Total owners Equities (stockholder's equities). For this example calculation, figures are taken from the sample Balance Sheet below:

     Total liabilities: $8,938,000
     Total stockholders equities: $13,137,000

Total debt to equities ratio
     = Total liabilities / Total stockholders equities
     = $8,938,000 / $13,137,000
     = 0.680

      Long term debt to equities ratio

Another debt to equities ratio, long term debt to stockholders equities, is less conservative than the previous ratio but more properly a measure of leverage, because the debt figure contains only debt to lenders, or long term debt, (as opposed to total debt, which includes debt to vendors, employees, and tax authorities as well as debt to lenders).  Using figures from the Balance Sheet example below: 

Total long term liabilities: $5,474,000
Total stockholder's equities: $13,137,000

Total debt to equities ratio
     = Total long term liabilities / Total stockholders equities
     = $5,474,000 / $13,137,000
     = 0.417

     Rules of thumb for debt to equities ratios

Average debt to equities ratios vary widely between industries, and between companies within industries. Even so, it is possible to present 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. If the company's ratios are substantially 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, but will also consider carefully the sources of the existing debt as well, along with the company's prospects for repayment. In other words, potential investors will consider the risks associated with existing individual debts, such as varying loan service costs with different loans. 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 rise above these values, loans become more difficult to acquire.

Increasing or decreasing owner's equity (Net worth)

As mentioned, owner's equity can be thought of as a company's reason for being because it represents the often-stated top-level objective for companies in private industry: Increase owner value. There are only a few ways that owner's equity can be increased or decrease.

Under a double entry bookkeeping/accounting system, as used by the vast majority of businesses, Equity balances are carried in equity accounts. Normal equity accounts carry a Credit balance and are increased by credit transactions. The same is true of normal liabilities accounts and revenues accounts. The balance in these accounts is decreased by Debit transactions.

By contrast, accounts classified as expense accounts or asset accounts carry a Debit balance, are increased by debit transactions, and are decreased by Credit transactions.

Increasing owner's equity through contributed capital 

Paid in capital (also called contributed capital) is a Balance Sheet account, showing what has been invested by stockholders through purchase of stock from the corporation (not through purchase of stock on the open market from other stockholders). When investors buy shares directly from the company, that is, the company receives and keeps the funds as contributed capital (paid in capital). When shares are bought on the open market, however, funds go to the investor selling them.

Contributed (paid in capital) capital is one of the two main owner's equity categories on the Balance Sheet. The other is retained earnings. Contributed capital, in turn, has two main components:

• Stated capital, which is usually defined as the stated, or par value of the shares of stock that have been issued ( the stated capital is listed on the Balance Sheet below is the cum of values listed for as "Preferred stock" and "Common stock.").

• Additional paid-in capital, capital contributed in excess of par  represents money paid to the company above the par value.

Contributed capital in both categories can thus flow company and add to owner's equity at the company's initial public stock offering (IPO), and again later as additional stock is issued (For more on the difference between par value and capital contributed in excess of par, see the encyclopedia entry par value).

Increasing owner's equity through retained earnings

Whereas contributed capital does add to owner's equity, company owners will hold management responsible for adding to owner's equity primarily by earning profits and then using profits to grow retained earnings. 

For purposes of financial accounting, a profit making company can do only two things with profit earned: (1) distribute to shareholders (the company owners) as dividends or (2) keep some or all of the profits as retained earnings. Many companies divide profits for both uses each year.

The disposition of earnings (profits) for each reporting period is published 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 of Retained Earnings is viewed as a bridge between the Income Statement and Balance Sheet. 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.

The basic Statement of Retained Earnings equation is as follows:

Net income
     = Preferred stock dividends paid
     + Common stock dividends paid
     + Retained earnings

This equation can be solved for retained earnings:

Retained earnings
     = Net income
     – Preferred stock dividends paid
     – Common stock dividends paid

Retained earnings, in other words, are the funds remaining from net income after dividends have been paid to the owners (shareholders). Each period's retained earnings are added to the cumulative total from previous periods, to create the current retained earnings balance.

In the example Statement of Retained Earnings below, retained earnings at the end of the previous reporting period and beginning of the present period stood at $2,660,000 (this figure would come from the previous year's Balance Sheet, under owner's equity). For the period, the company earned (reported net profits on its income statement of) $2,172,000. If the company were to pay no dividends, retained earnings would now be the sum of these two figures, $4,832,000. The company did elect to pay dividends totaling $1,134,000, however, leaving retained earnings at the end of the period 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 growing owner's equity).

It should be mentioned that the above example refers to cash dividends. Companies may also issue stock dividends to shareholders, in which case owner's equity decreases, but paid in capital increases by an equal amount, thus having no overall impact on owner's equity.

Decreasing owner's equity.

In small, privately held companies it is not unusual for the owner (or owners) to withdraw funds from the company from time to time by using a withdrawal account to take funds directly from an owner's equity account. Such an account is an equity contra account, sometimes called a drawing account.  This reduces owner's equity. Such withdrawals and reductions to owner's equity are much rarer in public companies with large numbers of shareholders. 

The more usual means of reducing owner's equity is the payment of expenses. In fact, the general definition of "expense" refers to its impact on owner's equity: Expense is defined as a decrease in owner's equity caused by the using up of assets in producing revenue or carrying out other activities that are part of the entity’s operations.

Balance Sheet example with owner's equity (Net worth)

Owner's equity is one of the three main sections of the Balance Sheet, as shown in the example below. Note, however, that many corporations will identify owner's equity as Stockholder's Equity for the Balance Sheet.

The other two main sections are Assets and Liabilities.

Example Statement of Retained Earnings

Retained earnings figures for the examples above were taken from the example Statement of Retained Earnings below.

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