What is Owner’s Capital or Equity Financing?
Before we begin to understand what Owner’s capital is and what Equity financing is to an organization, it is important to understand some basic accounting terminologies. A double-entry bookkeeping system Normal account balances are those which are expected to have either a debit balance or a credit balance, depending on the nature of the account. An asset account will have a debit balance as normal balance because an asset is a debit account. Similarly, a liability account will have the normal balance as a credit balance because it is amount owed, representing a credit account. Equity is also said to have a credit balance as its normal balance. However, sometimes the normal balances may be reversed, often due to incorrect journal or posting entries or other accounting/ clerical errors.
Owner’s capital is also known as owner’s equity which represents the net assets held, which is the amount left over after all the assets (debit balance items) have been sold and the creditors (liabilities or credit balances) have been paid. Liabilities include and represent the amount owed by the corporation or owners to external parties such as loans, debts, salaries, payments to vendors and creditors. Owner’s Equity is the financial yardstick of the company, especially if the company is traded publicly. It changes the perception of the company in the eyes of the public, and the relevant market conditions surrounding it.
While the term ‘owner’s capital’ is used in a sole proprietorship sense, its equivalent for corporations is ‘shareholder’s equity’ or ‘Equity financing’ where the owner may be replaced by shareholders. While sole proprietorships can take decisions unilaterally and partnerships via a majority, companies offer voting rights to the shareholders, effectively making them the owners of the company.
In the case of a sole-proprietorship or partnership (or a Limited Liability Partnership/Company-LLP/LLC), the amount contributed by the owner or the partners in the form of money or assets will be held as owner’s capital and shown on the liabilities side of the balance sheet. The net owner’s capital will be arrived at by adding any further capital added deducted by any withdrawals made by the owner or the partners. However, in a corporate context, there are some additional items or components to be considered. They are addressed in the following section.
What are the Components of Equity Financing?
This is the amount contributed (capital contribution) by the owners or the stock/shareholders of the company. It is shown at par on the liabilities side of the balance sheet, representing credit balances, i.e., amounts due by the company to the owner.
Retained earnings is the amount of profit that is derived from the income or profit and loss statement that is ploughed (reinvested) back into the business (to add to future profits) and not declared as dividend. As the company grows bigger and more profitable, its retained earnings may also grow, so as to constitute one of the biggest components of the Owner’s capital.
For example, for Financial Year 2019-2020, if company LMN earned a net income of $2 Million and decided to distribute $0.5 Million in dividends to its shareholders, then company LMN may choose to reinvest $1.5 Million back into the business in the form of retained earnings.
Additional Paid-in Capital
This amount represents the money that shareholders pay to purchase shares above the par value of the stock (i.e., at a premium). It can be computed by using the following formula:
(Issue price – Par value) x Number of shares issued
Treasury stock represents the amount of shares or stock that have been repurchased from the investors. It is deducted from the total equity of the company to effectively arrive at the actual number of shares available to investors.
Outstanding shares represent the value and number of shares that have been sold to the investors but have not been repurchased by the company. In effect, they represent shares outstanding by the company. This is a very important component in computing the owner’s equity.
Other Comprehensive Income
There are some items that are included as part of the equity but are not routed through the profit and loss account such as unrealized losses or gains (or foreign currency exchange fluctuations) that are not recognizable in the current period. These items are added to or deducted from the equity capital.
How does one value Owner’s Capital?
While it may look like the value of owner’s capital is prima facie the difference between assets and liabilities, to actually compute the value of a business, various other factors are also taken into consideration. These may include the cash flows of the business, projected cash flows, substantial decisions taken by the management, the fair market value of the company’s assets, and the valuation of intangible assets such as goodwill and intellectual property (also asset accounts which represent a debit entry).
Sometimes, the organization may have a negative owner’s equity because the total liabilities exceed the total assets. In this case, the owners may have to invest additional capital (in the form of venture capital or any other form of funding), or in the case of a company, the company may eat into its retained earnings. This is a sign of financial instability for the company, and it may have to reassess its financial position.
In order to determine the equity value of the company, there are several methods of valuation. One must first ascertain the value of the shares attributable to the company’s investors.
Equity value = Share price x Number of outstanding shares
Return on Equity (ROE) is the basic accounting equation to measure the financial performance and investment returns of the company. It is arrived at by dividing the net income by shareholder’s equity. This higher the ROE, the better the performance of the company. It is usually measured against an industry average for shareholders to determine how their company is faring as opposed to market standards.
Return on Equity =
- Net income is the amount of income deducted by expenses and taxes
- Average Shareholders’ Equity is the average of the equity held by shareholders across the fiscal period
Return on Equity is used to calculate growth rates, and it can be computed by multiplying the ROE by the retention ratio. As the name suggests, the retention ratio is a percentage of the net income that is retained and reinvested by the company unto itself.
A debt-to-equities ratio determines the proportion of a company’s liabilities to the shareholders’ equity. A higher debt-to-equities ratio determines a higher risk to the shareholders.
Paid-in capital: (Issue price – Par value) x Number of shares issued
Equity value = Share price x Number of outstanding shares
Return on Equity =
Some of the common possible errors while computing the various variables of Owner’s Capital/Equity Financing are as follows:
- Inaccurately computing the net assets including goodwill valuation or retained earnings.
- Omitting or making inaccurate postings of the debit balances/ credit balances or incorrect computations of profit/ loss in the profit and loss account/ net income statement.
- Inaccurately computing the holding pattern or the number of outstanding shares, which is an essential part of arriving at Shareholders’ Equity.
- Incorrect derivation of the Return on Equity based on the above inaccuracies.
Context and Applications
This topic is significant in the professional exams for both undergraduate and graduate courses that have accounting and commerce at its core. This may be especially applicable for:
- B. Com
- MBA (Finance)
Professional certifications including:
- Chartered Accountancy;
- Certified Public Accountant (CPA);
- Association of Chartered Certified Accountants (ACCA);
- Certified Internal Auditor (CIA)
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