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Equity equals ownership. The easiest way to think about this is if you own a home and it’s worth $500k and you have a $250k mortgage. How much of your home do you actually own? The answer is you don’t own the full $500k because if you sell it, you still have to pay off the remaining $250k loan balance.
It is the difference between the fair market value and your loan. When it comes to business, think about it in basic terms of equity is ownership.
The term “owner’s equity” is also known as shareholder’s equity or stockholder’s equity if the business is structured as an LLC or a corporation.
There are two different kinds of equity in business:
Equity on your financial statements is similar to a piece of real estate. It is the assets that you have inside of your business minus the liabilities equals your ownership (Assets-Liabilities = Equity)
Most small business owners have 70-80% of their net worth tied up inside of the equity ownership of their business. If you’re in a business that has a patent or technology that somebody could use and make millions of dollars from, your ownership maybe valued at whatever those patents are worth regardless of how much money you’re making. For most businesses though, it’s a measure of how much cash you can generate with the business very similar to a real estate investment.
While you can find equity on your balance sheet, a measure of your financial strength, ultimately ownership and the real equity that you have in your business comes from its ability to generate cash. Owner’s equity is an asset to the business owner themselves, not the business even though it is listed on the balance sheet. If you can generate more cash, you’ll generate a higher value for your business.
To conclude, increasing the owner’s equity every year in a business shows that it’s successful. Just make sure that the increase in equity is because the profitability of the business is increasing and not the contributions from the owner. This will give you a clear picture of how the business is growing in value and ultimately making you more successful.
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