Owners Equity, Capital and Retained Earnings

Introduction to Owners Equity

Owners Equity is that part of your business finance which is provided by the owners.

Equity includes two main components capital which is invested as cash or cash equivalents by the owners as a capital introduction and retained earnings which represent mainly profits of the business which have not been distributed to the owners.

Equity = Capital invested + Retained earnings

Equity is a major component of the basic accounting equation:

Double entry bookkeeping and accounting is based on the Basic Accounting Equation which states that the total assets of a business must equal the total liabilities plus the shareholders equity.

Assets = Liabilities + Equity

One side represents the assets of the business (buildings, inventory, vehicles etc), and the other side represents how those assets were funded (capital, retained earnings, loans, supplier credit etc.). Notice that owners equity includes amounts invested by the owners (capital) and retained earnings of the business which.

Owners equity is part of the balance sheet and is shown under the heading Capital & Retained Earnings.

It is important to understand that Retained Earnings are part of Shareholders Equity, they represent accumulated profits (and losses) of the business which have not yet been distributed to the owners, but which belong to the owner not the business.

Equity Example

Equity will change depending on whether the business makes a profit or loss even though no additional capital (cash) is injected by the owners.

For example, in year 1 if the Owners inject 1,000 the balance sheet will be as follows:

Year 1: Balance Sheet
Net assets 1,000
Net assets 1,000
Capital 1,000
Retained Earnings 0
Owners Equity 1,000

In Year 2 the business makes has net income of 500 and retains this within the business, the balance sheet will now be as follows:

Year 2: Balance Sheet
Net assets 1,500
Net assets 1,500
Capital 1,000
Retained Earnings 500
Equity 1,500

The equity has increased by the 500 increase in retained earnings which is equal to the net income of the business.

Last modified November 14th, 2018 by Team

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