If you were to sell off everything in your business at book value and pay off your debts, how much cash would you be left with?
That’s shareholder equity.
In other words, shareholder equity is the amount of the business that the owners own. (The amount that is owed to others such as banks, bondholders, etc. is the liabilities.)
Example: If you invest $1,000 in the business and you borrow $1,000, you’ve got $2,000 in assets. You owe $1,000—this is a liability because you owe it to the bank. And you own $1,000—this is your shareholder equity.
When you make a profitable sale, you grow the amount of assets you have. If you retain that profit in the business rather than taking it out, it adds into the shareholder equity, not into what you owe the bank.
There are two ways to calculate shareholder equity:
- By adding: How much you invested in the business (“Capital Stock”) plus how much profit you’ve made and retained in the business (“Retained Earnings”)
- By subtracting: The book value of everything in the business (“Total Assets”) minus the amount you owe to others, e.g. suppliers, banks (“Total Liabilities”)
Both of those calculations should give you the same number: shareholder equity.
Example: Let’s say you start a business selling pottery at the local farmer’s market. You put $10,000 of your own money into the business and borrow $5,000 from the bank to get equipment. Your total assets are $15,000.
Then, you go out to suppliers and pay $500 for pottery, which you are able to sell at the market for $1,500.
You’ve made a $1,000 profit on the pottery, and your assets now total $16,000: the $10,000 that you put in, plus the $5,000 from the bank, plus your $1,000 profit.
How much is your shareholder equity? It can be looked at in two ways:
1) By adding: How much you invested in the business plus how much profit you’ve made and retained in the business: 10,000 + 1,000 = $11,000.
2) By subtracting: The full value of your assets minus the amount you owe to others: $16,000 – 5,000 = 11,000
As long as you can continue to make a profit, your shareholder equity grows and grows.
For a more in-depth explanation of shareholder equity, read this article by Zacks
Also, check out this chart highlighting Hewlett-Packard (HP); HP started in a garage and now has 26.7 billion dollars in shareholder equity!