What is Owners' Equity

It is important for all businessmen to be aware of what owners' equity is and how it is quantified. In this article, we explain the concept, along with the formula used to calculate the same.
The concept of owners' equity is very simple to understand. It is the right of the owner over the assets of a business which he is running. This concept is related to two types of businesses - sole proprietorship and publicly traded companies. In case of the latter, it is generally referred to as stockholder's equity. It allows us to understand how much stake owners have in the company or business.

Calculation Formula

The stake that an owner has can increase or decrease, depending on his actions. The most important factor on which owners' equity depends is the profitability of the firm. The more the profits generated by the firm, the more value it will acquire. The equity that an owner possesses can be calculated by subtracting the liabilities from the assets.

Owners' equity = Assets of the Firm - Liabilities of the Firm.

This formula also enables us to understand how you can increase the equity. By simply paying off all the debts and liabilities that a business has, you can raise your equity in the company. If the company is successful in paying off the debt component completely, then the equity will naturally rise to a great extent.

Another way of increasing equity is to increase the monetary contribution from the owner. We often hear stories about promoters of a company raising their stake in their companies by buying shares from the open market. This is done by promoters to benefit from the future profits earned by the company.

Owners' equity increases substantially with the help of the retained earnings concept. Companies often sit on a large amount of cash and preserve it for a long period of time, instead of distributing the money to the shareholders in the form of dividends. This helps hike the equity that the owners have in the company.

High owners' equity can be considered to be a good sign for retail investors. This is because it usually shows that the promoters are keen on business expansion and increasing the profitability of the business. With a rise in profits, the shareholders can benefit from stock price appreciation in the long term by holding on to the stock. A very positive sentiment can be generated in the market about a company, if the equity is substantial. Many times, this is also referred to as the book value of the company.

There are many advantages of knowing the book value of the company. Many analysts use it to determine the valuation of stocks. If the current market price of the company stock is greater compared to its book value, it is termed to be an expensive investment. On the other hand, if the market value of the stock is lesser, compared to its book value, then it is considered undervalued, and a good investment target. It is recommended that investors consider owner's equity to invest in the right company and get superior returns.