What Does Equity Mean?

What Does Equity Mean

In this post you’ll find out what ‘Equity’ means in Accounting. I’m going to give you two definitions. Then we’re going to break it down to see what it’s made of and take all of the pieces and fit them back together to get a complete picture of what Equity is, and how it fits into the expanded Accounting Equation.

Equity, the third and final pillar of the Accounting Equation which looks like this… Assets are equal to Liabilities plus Equity.

Assets = Liabilities + Equity

Equity is the oddball in the Accounting Equation and there are so many different terms and jargon that come with it as part of the parcel. Wow so many! And this isn’t even all of them, but I’ve cherry picked these ones to teach you today because if you can understand these then you’ll have a solid grasp of what Equity means and to be honest you’ll be far ahead of most of the other people out there who is still battling with this topic.

Equity Definition

#1 Definition

Equity is the residual value of an entity’s assets after deducting all its liabilities.

I’ll explain how this works… First, let’s bring up the Accounting Equation again. Assets are equal to liabilities plus equity. If we rearrange this formula then we can see that equity is made up of assets minus liabilities.

Equity = Assets – Liabilities

Now we Accountants have another word to describe assets minus liabilities Net Assets. I said a moment ago that equity is the residual value of an entity’s assets after deducting all its liabilities. Residual value basically means what’s left over after you take all of an entity’s assets and deduct its liabilities. In other words… what we’ve got here. Equity represents the net assets of a business.

#2 Definition

Definition number two is gonna help us shed some light on this. It says that,

Equity represents the net funds invested into a business by its owners.

I like this description of Equity because it gives us some context. Let me explain with the help of the accounting equation. On the broadest scale there are two ways that funds can be invested into a business to finance its operations and you’re currently looking at both of them. It could choose to borrow money from third-party lenders like banks which in essence are liabilities, or it could choose to use the net funds invested into the business by its owners. In other words, it could choose equity.

Also Read: What is Free Cash Flow?

So now we know that equity represents the net assets of a business and at the same time it represents the net funds invested into the business by its owners. So what we’re saying here is that the owners of a business own, or have a claim on all of its net assets, And we call this equity. Make sense? Now that we’ve got an idea of what equity means, let’s have a look and see what it’s actually made of.

Full disclosure here… Equity is made up of a lot of things and some parts are a bit complicated but I mentioned at the start that I’ve cherry picked the parts that I think are most important. That will give you the most value. 3 in particular that together will give you a solid understanding of what equity is. And I’ll share them with you in a moment.

But first I think will be easier for you to picture all of this if we work with an example… Imagine that you’ve got an idea for a business. You’ve been following the ‘Plastic Free Feb’ movement on the internet and you’ve come across this video… 90% of all… Gross… You realise that plastic makes up 90% of all ocean debris.

So you come up with an idea to decrease the number of plastic bags by developing your own reusable shopping bag to help save the planet. But there’s a problem… You have a choice to make that all startup businesses end up facing… How to structure your business.

Sole Proprietor

You could choose to go it alone, become a sole proprietor and avoid incorporating the business as a separate legal entity. You could go in 50/50 with a mate and form a partnership. Or you could decide to create your own corporation. A separate legal entity that’s owned by its shareholders. Now there are pros and cons to each of these but that’s for another day.

Let me know down the comments if you’d like to hear more about it. I want us to rewind for a second… I said that equity is essentially made up of three things, and the reason why I’ve laid all this out here is because the words we used to describe these three things changes depending on the structure of the entity. And I think that’s partly what makes equity seem so complicated. There is so much different jargon that we used to describe what is essentially the same thing.

Capital Contributions

The first thing that makes up equity is capital contributions. Capital relates to the funds raised to support a business and contributions simply mean that these are given to the business. So capital contributions is the money that the owners invest into the business out of their own pockets. Now the way that we describe this changes depending on who the owners are. And that changes based on the structure of the business.

If you’re a sole proprietor then there’s only one owner, you, so you’d call the money that came out of your own pocket… Owner’s equity. However if you were part of a partnership then the owners of the business would be the partners so you’d call the capital contributions… Partner contributions. And if you created a separate legal entity, a corporation then the owners of the business would be the shareholders and you’d call the funds invested shareholders equity.

So we have three different terms that describe basically the same thing. Capital contributions are one of the ways that businesses tend to fund themselves during the early start up phase, before they’ve become profitable. Imagine that you choose to become a sole proprietor, at least at first. And you invest $1,000 of your own money into your reusable bag business. What’s your business’s financial position?

Let’s bring up the accounting equation again. Your business has assets of $1000 in the form of cash. And you, the owner have a claim of $1000 on those assets which we call owner’s equity. The accounting equation is in balance, as it should be because when we’re looking at a snapshot of a business’s assets liabilities and equity at a single point in time we’re looking at its balance sheet.

Now capital contributions aren’t the only thing making up equity… When your business generates revenues or incurs expenses it’ll make a profit or a loss. Which is just revenues less expenses. What happens to that profit? And who does it belong to? You of course! You’re the owner. So you could choose to reinvest these profits back into the business, or hold on to them to use in the future. Over time these profits and losses that you’re holding on to build up and we call them retained earnings.

Retained Earnings

Retained earnings are defined as Accumulated profit held for future use. And thankfully this term stays the same regardless of whether you’re a sole proprietor, a partnership or a corporation. Your business’s equity is made up of two things… Capital contributions and retained earnings. Over time your reusable bag business starts to make some real money, so much in fact that you no longer need to dip into your own pocket to fund it using capital contributions.

You can cover all of the expenses using the accumulated profits that you’ve held on to and set aside. Your retained earnings. Within a year your business is booming. You’ve got much more money coming in than what’s going out. In other words, you’ve got a net cash inflow. But back home, all is not so rosy you’ve invested so much of your own savings into the business through capital contributions that you are running out of money to live on for yourself.

You need to withdraw some cash out of the business to cover your own personal expenses. Well how does that work? Retained earnings are made up of a couple of things… Remember I said that they’re your accumulated profits held for future use. So a big chunk of your retained earnings is your accumulated profits. Which are your revenues less your expenses. Which comes straight from your income statement.

An income statement is a financial report that you use to track your revenues and expenses over a period of time. But retained earnings are also made up of withdrawals. The money that’s taken out of the business and distributed to its owners.

Withdrawals

We have different terms to describe withdrawals depending on the structure of your business. For sole proprietors we call them drawings. And for partnerships we call them partner drawings. And for corporations we call them dividends. Which a profits distributed to the shareholders. Again we have three terms, all used to describe what is essentially the same thing. Withdrawals.

As the sole proprietor of your reusable bag business you can use drawings to withdraw your accumulated profits for personal use. This impacts the accounting equation by decreasing assets because the business’s cash has gone down and decreasing equity because your claim on those net assets has decreased. Hold on, now I want to show you something interesting… We’ve broken equity down into capital contributions, retained earnings and withdrawals, but let’s see how this all fits together using the accounting equation.

How the Expanded Accounting Equation works

Earlier I said that when we look at a snapshot of the accounting equation at a single point in time, we’re looking at a balance sheet. The balance sheet is made up of three things – Assets, liabilities and equity and we know that equity is made up of capital contributions from the businesses owners and retained earnings. Which are its accumulated profits held for future use.

Retained earnings break down further still into accumulated profits less withdrawals. And accumulated profits are a business’s revenues less expenses. Which when looked at over a period of time make up its income statement.So what we’ve got here is the expanded accounting equation. And I like this because we can see how two of a business’s major financial statements, the income statement and the balance sheet are linked together through equity.

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