What is equity in business?

Equity (definition)

Equity is the money an owner would keep if they sold their business. It accounts for any debts they have to repay on the business or its assets.

People keep track of equity in business to ensure their debts don’t exceed the value of their assets. Positive equity means proceeds from the sale of a business would clear debts, with some left over. Negative equity means the sale wouldn’t clear all your debts. You’d still owe money.

A business that has negative equity is said to be insolvent. In many countries it’s illegal to continue operating a business once it becomes insolvent.

How to calculate equity in business

Equity formula:

For a business, you would calculate equity by adding the value of all its assets (which are things it owns), like property, buildings, equipment, cash, and money owed by customers. Then you would subtract all the amounts the business owes to suppliers, employees, lenders and the tax office. What’s left is the equity.

When selling a single asset, the equity is the book value of the asset minus any debts owed against it. If your business owns a truck, for example, it is the market value of the truck minus any repayments you still owe on the truck.

Equity vs owner’s equity vs net worth

Equity and owner’s equity are the same thing. In business, it’s more common to use the full term, "owner’s equity". It may be called shareholder’s equity in the case of a company or corporation but a shareholder is really just another name for an owner.

Owner’s equity is also the same as the net worth of a business. It reflects how much money would be left if the business was closed, liquidated (all assets sold), and its debts were settled.

Why equity matters

Equity measures the net value of the business, which means it’s relevant to:

  • negotiations when selling a business
  • lenders who want to see that you can secure loans
  • investors who want to know what their investment is worth
  • insurers who might underwrite the business

It’s also important to ensure the business has positive equity as a business with negative equity is generally said to be insolvent and may not be legally able to continue.

How equity changes

Equity generally grows as a business does work, banks profits, buys new equipment, and builds or adds facilities. Anything that’s recorded as an asset on the balance sheet will add equity to the business. On the other hand, liabilities will reduce equity. Common types of liabilities include unpaid bills, tax dues, loans and payroll owed to employees.

Taking a loan to buy a new asset generally has a neutral effect on equity because the value of the asset and the loan are generally equivalent. Equity will go up as the business gradually pays off the loan.

Where equity is recorded and how it’s reported

Owner’s equity is recorded at the bottom of the balance sheet, after the assets and liabilities. It’s calculated at the end of each accounting period and will form part of your end-of-year financial statements.

Owner’s equity is also reported in the statement of owners equity. This is another of the four major financial statements produced as part of globally recognized International Financial Reporting Standards.

See related terms

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Disclaimer

This glossary is for small business owners. The definitions are written with their requirements in mind. More detailed definitions can be found in accounting textbooks or from an accounting professional. Xero does not provide accounting, tax, business or legal advice.