In previous posts, we discussed Assets and Liabilities. Now we will talk about Equity. When it comes to the three elements of accounting, Equity is actually pretty straightforward. It is the residual interest in the Assets of a company that remains after deducting its Liabilities. When you take the value of the business’ Assets and subtract the business’ Liabilities, whatever is left over is the Equity.
Example: Company car (Asset) valued at $15,000. Loan (Liability) amount at $10,000. The remaining $5,000 is Equity.
Another way to look at Equity is it being whatever is left to the owner(s) of a business after all Liabilities are settled.
Why is it important?
Equity tells you about your business’ finances. You can look at Equity over time and determine if you are making or losing value. From there you can make better decisions like whether to expand, if you should look at investing, or if you should look to be more conservative. Equity is also something investors and lenders will review when your company looks for financing options.
Types of Equity
The Equity portion of your company’s Balance Sheet is broken into several categories. These categories can vary depending on the entity type of your business.
Owner/Member/Partner Contribution - This is money you put into the business. If you buy a desk with personal funds, this is a contribution. The cash you invested to start the business is a contribution.
Owner/Member Draw or Pay - This is money you take from the business. When you pay yourself (AND YOU SHOULD PAY YOURSELF), this is a draw. This will be a negative amount as it is money leaving the business entirely.
Retained Earnings - This is the accumulation of all previous years net income that has not been paid out in dividends.
Net Income - Net income is what happens when you take Gross Income/Revenue (money made by your business) and subtract Expenses (money spent by your business). On the first day of the new tax year, Net Income is moved to Retained Earnings. Note: your accounting software should automatically do this for you.
The combination of these Equity accounts will give you your total Owner’s Equity.
Tips For Sole Props and Single Member LLCs
Be sure to have separate personal and business accounts. This includes checking accounts, savings accounts, and credit card accounts. Doing this will make it easier to do your books in general but, in regards to Equity, it will also allow you to better determine when you put personal money into the business and when you take money out of the business for personal use.
Put yourself on a pay schedule and pay yourself from the business account. Take that money and put it in your personal account. Using your business account like a personal account is a big “no-no” and a big headache when it comes to your bookkeeping. Paying yourself what you're worth is not only important for your morale but also will allow you to separate your business and personal expenses. Also, it will allow you to more accurately track your Owner/Member/Partner Draws and Contributions.
On the 1st of the new year, create a Journal Entry in your accounting software to move your Owner Draws balance to your Owner Contribution account. You do this because you want to be able to see what your Owner Draws are every single year.
That’s the skinny
Equity is your stake in the company. It is the remaining value of the company when you’ve settled all its Liabilities. It is key to understanding your business’ financial health and in determining how to move forward when making business decisions. It is also a factor when looking at finance options with lenders and investors. Make sure you have processes and practices in place that will help you keep Equity accounts tracked accurately and timely. Remember, if this is something you would prefer to leave to a specialist (aka a Professional Bookkeeper), feel free to schedule a free consultation!