Understand your company equity and how it breaks down in your company structure.
As we close out talking about balance sheet accounts, we can’t forget about our company equity accounts and what they are. Luckily it is the simplest of all the accounts and generally the smallest area because, quite simply, equity is simple.
What value of assets is left over after you pay all of your debt, which is liabilities, is your equity. That’s it, nothing complicated, no confusing lingo or jargon. Just add all your assets up and subtract all your liabilities, and that is your company equity.
Well, I am not going to just leave you hanging with that vague response because while equity is simple, it is not that simple.
There are really three areas in your company equity, like assets and liabilities, which break down into quite common and easy-to-understand accounts. Equity breaks down into new equity, long-term equity, and owners/shareholders equity. When I say new equity, I refer to your total net income for the tax year. Month after month, that net income adds up and is shown as net income on your balance sheet throughout the tax year. Ultimately by the end of the year, it shows you your net from all 12 prior months of the tax year added together. Still, this must reset to zero at the end of the year and increase another account or decrease it.
Long-Term Equity or Retained Earnings
That leads to long-term equity or retained earnings. Retained earnings look at the net profit from all previous years and add it up, so every year you do well, retained earnings increase. Every year you do bad, retained earnings decrease. Ultimately this account is exactly the same as net income. However, rather than adding up months and resetting after 12 months, it adds up years and never resets. Another long-term asset account that can exist in long-running files that may have at one point gotten messy, it happens to everyone, is an opening balance equity account. This account can be used by someone to clean up a prior mess, or if you are a brand-new business or changing your business type/buying another business, you could have assets that exist before the existence of your business. Many accountants will try to make this disappear if possible as it should not exist long term. Still, sometimes that can prove very difficult to do when matching up to old tax returns.
Owner or Shareholder Equity
The final accounts we see are owner or shareholder equity. Many owners or shareholders will put in money to start their company or expand it from time to time resulting in the fact that we need to show what they put in so that it can eventually be pulled back out. Some owners will call this a loan, and thus, instead of equity, it will show up as a liability, both of which have pros and cons. At the same time, owners will sometimes accidentally or more regularly purposefully take money from the company, not through a paycheck which is regularly called an owner’s draw. This is ultimately money that the company makes and shows as net income, but you as the owner take out of the bank account, and thus we have to show it as such. This shows up at the end of the year on your tax return. Still, we consider it this way because anything the owner is paid ultimately is profit the company could have made. Hence, we want to track that to be able to sell the business eventually.
One financial flag is negative company equity!
Company equity accounts can be negative, and some, like owner’s draw, quite regularly are. As stated, multiple bad years can lead to negative retained earnings, or even the current year can lead to negative net income. Negative equity can just mean that the company went through a rough patch but is now recovering or recovered. This is quite common, but negative equity can also mean that you are in so much debt that your assets have no way to pay it off. While this is recoverable, this is never a good place to be in as it can lead to the business closing. Negative equity is one of those financial flags that you want to keep your eyes open for to make sure that we avoid it, and if we get to the point that it happens, have a plan out of the situation.
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