Check out this week’s video on Owner’s Equity!
So in last week’s video, we talked a lot about the Balance Sheet. I wanted to make a video specifically about Owner’s Equity. I feel like a lot of people focus most of their time on understanding assets and liabilities. But Owner’s Equity is just as important, and I am going to focus on two main reasons.
- Capital Structure
So it’s very important that you understand what is going on in Owner’s Equity.
Let’s start with capital structure. Capital Structure is the way a company finances its assets with a combination of equity and debt. It is usually represented by the Debt/Equity ratio. So when we talk about capital structure, it is all about understanding who has claims on the company’s assets.
To illustrate this, let’s think of a very simple company. Let’s say this is a sole owner that puts all their own money into the business. Their balance sheet might look like all cash and all equity. Now as the business operates, it starts taking on debt. This increases liabilities, and decreases the claims to the assets in owner’s equity. Or if the business liquidated, how much the owner’s are entitled to. So this is a very simple example, but it extends out to global billion dollar companies. If you are buying stock in a company, you should look at the balance sheet. It will tell you, when you purchase stock in the company, how much claim do you really have against company assets. Does the company have a lot of bank loans? The banks then have more of a claim to the assets than you do. So that’s important to look at. How strong is your claim as an owner over the assets of the company.
Now I don’t want you to misunderstand me here. If you are purchasing a stock, there is much more that goes into the decision than Owner’s Equity. The valuation of a stock is primarily driven by the expectation of future dividend payments, which the balance sheet tells you very little about. However, my point is that it is important to understand where you stand within a company’s capital structure and what that means for you. Because I’ll tell you something else. When a bank looks at a company to give them a bank loan, they look very carefully at capital structure, and where they stand versus other creditors who have claims to the assets of the business. So capital structure is very important.
One other point of clarification, there is no ultimate capital structure. Having a lot of debt, might not be a bad thing, because there is tax benefits that go along with it. That debt might be leading to greater profits for the owners. So there is no one capital structure that is better than another. My point is simply to understand what capital structure you have and the implications to your standing in the company.
Second, let’s look at liquidity. Liquidity refers to a company’s ability to pay liabilities with assets. So if you were to liquidate the company, sell the assets and then use the cash to pay off outstanding debts, how much money would be left. There is a financial ratio called the Quick Ratio or the Acid Test ratio. This is current assets (except inventory) over current liabilities. You want to exclude inventory, because sometimes you can’t sell it off as quickly. So this is telling you whether you have enough assets to cover your current outstanding debt.
So you might be asking, so what does this have to do with Owner’s Equity? It’s not even in the equation? Now I really want you to listen to this, because it is so important to understand. Liquidity is really about understanding your current portion of Owner’s Equity. Because let’s think about what you are really asking. You are taking your current assets and subtracting current liabilities. What you really want to know is the dollar amount that is left after you pay your debts. Well what is that dollar amount? That is your current portion of Owner’s Equity. Now this amount is not listed on the balance sheet. You have to calculate it. So out of the total Owner’s Equity, we are looking at the current portion, or “how much money do you have free to operate your business.
This is the dollar amount you are really looking for when you calculate liquidity. And this is critical to know in your day to day operations of your business. And here is the trap you are trying to avoid. If someone asks you how much free cash you have, do not go and look at the dollar amount in your cash account. That is not how much free cash you have, because a lot of that money has claims on it for outstanding bills. Your free cash is really this Owner’s Equity amount. That is how much cash how have free to operate your business.
So to recap, it is really important to understand what Owner’s Equity means on a balance sheet. And I talked about two big reasons in this video: Capital Structure and liquidity.
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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.