A company's balance sheet reflects the financial health of that entity. Owner's equity, also referred to as capital, is an accounting term, and it is a major component of a balance sheet. It indicates the portion of a company's equities that a business owner has rights to in relation to assets and liabilities. Technically, owner's equity is an equation that subtracts liabilities from total assets.
Owner's equity can be expressed in a variety of ways. For instance, it represents any debts that are owed to a business owner. It also reflects any investment made by a business owner. If a company founder uses some of his or her own money to launch a new business, for example, the amount is noted in what's known as a capital account, or an owner's equity account.
Publicly traded companies issue a number of shares in the public markets for investors to buy and sell. The two primary types of shares are common stock and preferred stock, although both grant investors partial equity ownership in a company. The number of shares outstanding, which is the number of stocks held by investors, is also considered part of owner's equity.
Preferred stock grants shareholders the right to regular dividend payments at a predetermined rate. Common shareholders are general investors who receive dividend payments only as a benefit that is decided upon every quarter. In the event that a company is forced into liquidation, preferred shareholders are ranked higher and have a right to equity before common shareholders.
Retained earnings are another type of owner's equity. These are profits generated and preserved by a company over time. Instead of distributing these profits to investors in the form of a dividend or using the capital for a company expansion, earnings are retained, and this enhances the owner's equity stake.
An owner's equity stake increases or decreases over time. Once a company begins generating profits, those earnings are counted toward owner's equity. Capital withdrawals, dividend payments and losses produce a decline in owner's equity. In the United States, these changes must be noted in a company's balance sheet as part of Generally Accepted Accounting Principles, the accounting standard in the region.
Although a company's owners have equity rights to that entity, creditors do, as well. This is why it is necessary to subtract liabilities or debts from assets in order to determine an owner's right to equity. In the event that a company fails and enters bankruptcy, its creditors, including debt holders, have a right to capital before the owner has a right to equity.