Owners Capital Definition
Owners Capital is also referred to as Shareholders Equity. It is the money business owners (if it is a sole proprietorship or partnership) or shareholders (if it is a corporation) have invested in their businesses. In other words, it represents the portion of the total assets which have been funded by the owners/ shareholders money.
Owners Capital Formula
It can be calculated as follows:
For example, XYZ Inc. has total assets of $50m and total liabilities of $30m as at 31st December 2018. Then Owners Capital is $20m (Assets of $50m fewer Liabilities of $30m) as at 31st December 2018. It can be interpreted from above that assets of $20m are funded by the Owners/ Shareholders of the business. Remaining $30m have been funded through externally sourced funds (i.e., loans from banks, issuance of bonds, etc.)
Components of Owners Capital
#1 – Common Stock
Common Stock is the amount of capital contributed by the common shareholders of the company. It is shown at the par value in the Balance Sheet.
#2 – Additional Paid-In Capital
Additional Paid-In Capital refers to the amount over and above the stated par value of the stock that has been paid by the shareholders to acquire the company shares.
Additional Paid-In Capital = (Issue Price- Par Value) x Number of Shares Issued.
Let’s assume that as of 31st December 2018, XYZ Company issued the total number of common shares of 10,000,000 having a par value of $1 per share. Further, assume that common shareholders paid $10 each to acquire all the shares of the company. In this case, additional paid-in capital would be reported at $90m (($10-$1) x 10,000,000)) under shareholders equity in the Balance Sheet.
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#3 – Retained Earnings
Retained Earnings is the portion of net income available for common shareholders that have not been distributed as dividends. These are retained by the company for future investments and growth. Considering that the amount retained by the company belongs to its common shareholders, this is shown under shareholders’ equity in the balance sheet. It increases when the company makes profits and decreases when a company makes losses.
For example, if the company earned net income (after paying preferred dividends) of $5m for the financial year ending 2018 and distributed $2m as dividends to its common shareholders. This means that the company’s management has decided to retain $3m in the company for its future growth and investments.
#4 – Accumulated Other Comprehensive Income/ (loss)
These are some income/expenses that are not reflected under the income statement. It is so because they are not earned incurred by the company but affect Shareholder’s equity Account during the period.
Here are some examples of items. Other Comprehensive Income includes unrealized gains or losses on available for sale securities, actuarial gains or losses on defined benefit plans, foreign currency adjustments.
#5 – Treasury Stock
Treasury stock is the stock that has been reacquired by the company from the shareholders and thus reduces the shareholder’s equity. It is shown as a negative number in the Balance Sheet. There can be two methods for accounting treasury stock, i.e., Cost and Par Value Method.
Examples of Owner’s Capital Calculation
Below are the examples.
Example #1
Say ABC Ltd. has total assets of $100,000 and total liabilities of $40,000. Calculate the Owner’s Capital.
Calculation of the Owner’s Capital
- =$100000-$40000
- =$60000
Example #2
Let’s see a practical application. Tom runs a grocery store. He started it on 1st Jan’2019 with his savings of $40,000 and a loan that he took from his uncle for $20,000. He purchased a laptop for $1,000; furniture for $10,000; stock for $45,000 and balance $4,000 was kept in bank for day to day expenses. At the end of the year, i.e., 21st Dec’2019, his balance sheet stood at follows:
How these figures actually got changed? Let’s understand; Tom must have sold his stock at prices higher than the purchase price. He must have incurred some expenses like electricity, insurance, accounts, finance charges, etc.. Also, he might have made some connections, so he was able to purchase some stock on credit. All these events led to cash inflow as well as cash outflow. The profit he actually made after all these are now added to the Owner’s Capital.
Now if we calculate Owner’s Capital by using Assets – Liabilities formula then we get:
- =$71200 – $21200
- =$50000
Change in Owner’s Capital
- #1 – Profit/Loss: The owner’s capital changes every year due to profit or loss arises in business. Profit increases the owner’s capital while losing decreases it.
- #2 – Buyback: Buyback means repurchase of capital that was once issued by the company due to various reasons such as idle cash, boosting financial ratios, etc. It results in a decrease in the owner’s capital.
- #3 – Contribution: The owner’s capital increases when contributions are made by existing owners or by new owners. When new owners come into the business, then they contribute as per the ownership they will be acquiring.
Advantages and Disadvantages of Owner’s Capital
Given below are some of the advantages and disadvantages of the owner’s capital.
Advantages of the Owner’s Capital
- #1 – No burden of Repayment: Unlike debt capital, there is no burden of repayment in the case of the owner’s capital. It is thereby considered a permanent source of funds. This helps management to focus on its core objectives and flourish the business.
- #2 – No Interference: When a business has Debt as a major source of funds, the chances of interference by lenders are high. This can become a hindrance to the growth of a business. While in the case of the owner’s capital, management has sole discretion in deciding whatever is good for the business.
- #3 – No Impact of Interest Rate: If a company is highly dependent on variable rate debt capital, then an increase in interest rate can significantly impact its cash flows, while in the case of the owner’s capital, there is no impact of changes in interest rate.
- #4 – Easy Accessibility to Debt Capital When the company has enough owner’s capital, then it is always easy to get additional debt capital as it shows that the company is strong and working independently.
Disadvantages
- #1 – Higher Cost: Cost of owner’s capital is the return which such capital could have earned in any other investment opportunity. Since business always posses risk, so expected return from such capital is higher than the debt capital. Debt Capital is usually secured by a tangible asset.
- #2 – No Leverage Benefit: Interest expense comes with a benefit of tax shield, which means a company can claim it as a business expense. Like any other expense, it reduces the taxable profit. However, this tax saving is foregone in case of owner’s capital as dividend doesn’t account as a business expense.
- #3 – Dilution: Raising the new owner’s capital dilutes the holding of existing owners. However, this doesn’t happen in the case of debt capital. Business can grow with the use of debt capital, and at the same time, the valuation of such a business doesn’t get diluted.
Conclusion
Owners Capital is a vital part of any business. It is the base upon which the whole company stands and grows. Business can be carried out with only the owner’s capital or with debt or a mix of equity and debt. An optimal mix of shareholders’ equity and debt is considered as the best option to get leverage benefits. However, the owner’s capital is highly appreciated when the cost of debt is higher than the return business is providing.
Having a balanced owner’s capital shows that the company is secured and does not only rely on outsiders for carrying its business.
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