What is equity?

Definition

Equity is the residual slice of the business that belongs to the owners. On the books, this is assets minus liabilities, shown as its own section on the Balance Sheet.

The equation has to hold: assets equal liabilities plus this section. If it does not, the snapshot is not finished.

Cash-basis and accrual books both keep this residual. Accrual books include unpaid invoices and unpaid bills in the assets and liabilities that feed the math.

This section is the owners' claim, not the company's checking account. A bike rental can have a high residual and still be short of cash if that claim is tied up in bikes.

Where it shows up

Balance Sheet: Located below liabilities as the residual claim.

P&L: Related to net income that flows into this section.

Cash flow: Increases from owner contributions, reported cash from financing activities increases.

See also: Balance Sheet · Retained Earnings · Statement Of Changes In Equity

When you look at your Balance Sheet, this section sits at the bottom, below liabilities. The total is assets minus liabilities on that date.

When the total is high, the rental owns more than it owes. When the total is low or negative, liabilities have caught up with or passed assets.

The profit and loss statement does not list this section as a line. Net income for the period flows into Retained Earnings, which lives inside this section.

The Statement of Changes in Equity is the page that walks this section from the start of the period to the end. That ending total has to match the Balance Sheet.

On the Statement of Cash Flows, owner contributions are a financing inflow. Draws and distributions are a financing outflow; they reduce this section without hitting the P&L as an expense.

How it works

This section starts with what owners put in. A capital contribution raises cash and raises this residual.

Profit adds to it. After the close, net income lands in Retained Earnings inside this section.

A net loss subtracts. Cumulative losses can even turn the retained earnings line negative.

Owners taking money out also subtract. A draw or a distribution reduces cash and reduces this section; it is not an expense on the Income Statement.

Common stock and additional paid-in capital hold the share accounts for a corporation. A sole proprietor or partnership may show capital accounts by owner instead.

Book value of the business is this section's total, not a market price. A buyer may pay more or less than what the Balance Sheet residual says.

Every posted transaction still has to leave assets equal to liabilities plus this section. Buying a bike with cash swaps one asset for another and leaves the residual unchanged.

Buying that bike with a loan raises an asset and raises a liability together. This section does not move until profit, a contribution, or a draw shows up.

Example

A bike rental starts with $15,000 of cash from the owner and no loans. Assets of $15,000 equal this residual of $15,000.

The contribution at the start is recorded:

Debit: Cash $15,000

Credit: Owner's capital $15,000

Cash and this residual both go up by $15,000. That line is a contribution, not revenue.

The owner then buys $10,000 of bikes with cash. Assets stay $15,000, now $5,000 cash plus $10,000 bikes, and this section is still $15,000.

Later the rental earns $4,000 of net income and the owner takes a $1,000 draw. After the close, this section is $18,000, which is $15,000 plus $4,000 minus $1,000.

The $4,000 of profit is added through the close into Retained Earnings. The $1,000 draw reduces cash and reduces this section.

The Balance Sheet still has to balance. Assets of $18,000 must equal liabilities of $0 plus $18,000 of this residual.

Common mix-ups

Equity is not cash in the bank. Cash is an asset; this section is assets minus liabilities.

This section is not the Income Statement. Profit for one period flows into it; the P&L is still the story of revenue and expenses.

Retained Earnings is not the whole of this section. Retained earnings is the cumulative kept profit inside it; contributions and share accounts sit here too.

Related terms

• Balance Sheet: A statement showing what a business owns, what it owes, and what is left for owners at a single point in time.
• Retained Earnings: Cumulative profits kept in the business rather than paid out.
• Common Stock: The par-value equity account for shares issued to owners.
• Additional Paid-In Capital: Amounts investors paid above par value for their shares.
• Owner's Draw: Cash an owner takes out of the business for personal use.
• Distributions: Payments of profit out to owners or shareholders.
• Book Value: The equity value carried on the balance sheet rather than a market value.
• Statement Of Changes In Equity: A statement reconciling beginning and ending owner equity for the period.