The Three Things You Need To Know To Calculate Owner's Equity
In a previous post, we emphasized the importance of Owner’s Equity. As a key financial metric, Owner’s Equity is a piece of the financial puzzle every owner is encouraged to understand in order to make informed decisions. Of course this is not the only or most critical piece; it’s just another piece that is important to understand and use when appropriate. To fully understand how to use Owner’s Equity, it is important to understand how it is calculated and to have a process for calculating Owner’s Equity that is relevant to your business. This post details how Owner's Equity is calculated and offers considerations for different types and structures of businesses (i.e. partnerships, sole proprietorship, S-corporations, etc.)
How To Accurately Calculate Owner’s Equity
On the surface, the equation for Owner’s Equity can seem really straightforward:
Owner’s Equity (OE) = Assets - Liabilities
Previously, we defined Owner’s Equity as that portion of the business value that the owner would have if all other debts (short and long term) were paid and all income was received. From this basic equation, it seems that the balance sheet is the only tool needed to calculate OE. But wait! When we learn to use a balance sheet, we learn that Assets must equal Liabilities to “balance”. So, if that’s the case, how can we introduce OE into this equation? Simple:
Owner’s Equity’s (OE) + Liabilities = Assets
This is one of those cases where you sometimes need to work the equation backwards to figure out what the variables are. Looking at the equation in this manner is particularly important for companies with more than one owner, or that may be offering stock to shareholders. This has a link, also, to the Cash Flow Statement where we discuss sources of cash from financing.
Okay, so enough of the gibberish, right? Let’s break this down.
Defining Assets As They Apply To Owner’s Equity
This is usually the easiest group of “things” to understand. Assets are typically considered those tangible items that an organization owns and can be broken into two different groups:
Those things which go into the products or services the organization uses to generate revenue; and
Those things which support the organization's ability to operate.
As an example, if you are making ceramic mugs, your organization may have in the inventory 1000 pounds of ingredients for the clay used to make the mug. This inventory has value and adds to the total calculation of assets.
Likewise, your ceramic mug company also has fifteen reams of printer paper used to print letters, reports for management, or employee notification posters. These items are not sold to generate revenue, however the paper itself has value, which adds to the total calculation of assets.
Tangible asset value is potentially affected by depreciation (and in some cases, appreciation) so the rate of depreciation is considered in the total calculation of the value of an asset. Because Owner’s Equity changes as the assets and liabilities change, this means that, over time, if all other things are constant, if an asset appreciates, Owner’s Equity increases; likewise, the effect of depreciation is to lower Owner’s Equity over time.
In each of these groups, it’s easy to determine a quantitative equivalent. Data supporting the current value of an asset is abundant, especially with the advent of Craigslist or Ebay, let alone the number of equipment resellers that operate in most all manufacturing related industries. Accounting and finance courses at the university level typically truncate the academic discussion of asset value with tangible assets. However, there is a very important intangible asset that all owners need to understand when determining the value of their organization and that is “blue sky.”
Understanding The Impact Of Blue Sky On Your Assets
The concept of “blue sky,” or the increased value of your business due to intangible assets, is important as it can be a key topic of negotiations between current owners and potential investors or buyers. The definition of blue sky is often debated among different groups of analysts. For this discussion, we define blue sky as:
The effect of intangible factors such as environmental events, existing employee expertise, earned knowledge or capability of the organization that is not easily replicated, or established good will the organization has created in its working environment or its community on the value of the organization.
For example, the value of a commercial airliner such as Southwest Airlines was far greater in pre-COVID days because of anticipated earnings from selling plane tickets. Today, with so many concerns regarding personal safety, through no fault of their own, the value of airlines has substantially diminished. It wasn’t due to lack of planning or poor management; it was completely unexpected.
Likewise, the value of an RV campground prior to COVID-19 was substantially less than it is now as more folks are replacing airline tickets with RV rentals, and crossing the roads in a socially-distancing means. Again, through no effort of their own, the value of these RV parks and campgrounds seems to have “magically” increased.
Although we don’t show blue sky assets on the balance sheet, when calculating Owner’s Equity, it’s really important to capture the value of these intangible assets. An example of how to do that would be if you employed a subject matter expert, you might consider the value of replacing that individual should he or she determine it necessary to leave your organization. If it’s going to be really easy to replace the skills, knowledge and expertise, the blue sky value of the company as a result of employing that individual is not very high. However, if it is going to be very difficult to replace that individual, and that individual’s contribution to your organization directly results in increased earnings, the blue sky associated with that individual is very high.
The key to quantifying (or monetizing) blue sky is to know your organization’s strengths, weaknesses, opportunities and threats (SWOT - we’ll cover that in a future post). By understanding these four key attributes, you can then conduct research to see what other organizations are using to establish value in similar areas. However, it’s important that any owner understands that blue sky is negotiated each and every time a potential sale or investment opportunity arises and a marketing strategy evolves. Thus, it’s important for owners to periodically research their organization's worth especially in the non-tangible areas. To this point, an entire industry of valuation experts has become influential in helping owners, buyers and investors to determine meaningful blue sky asset value.
Blue sky is typically used to negotiate new financing terms (such as payback periods) or potentially a sale price for your visit. It is important to note, however, that blue sky is rarely used to obtain loans as most lending institutions do not consider blue sky as a tangible asset.
Defining Liabilities As They Apply To Owner’s Equity
Getting a complete picture of liabilities can sometimes be daunting. We have to think of every entity to whom we owe money or are obligated to provide some good or service. The easiest way to calculate total liabilities is to review the balance sheet. To calculate Owner’s Equity, all that’s needed is the total current and long term liabilities, which must include accounts payable (otherwise affectionately known as bills), accrued liabilities (such as employer payroll taxes which are paid monthly even though paychecks are made weekly), short- and long-term debts (for example credit card balances and capital equipment loan), deferred income taxes, and potentially accrued benefits if your organization provides health care or retirement programs for your employees.
There isn’t a direct equivalent to blue sky for liabilities, however, as discussed above, if the value of intangible assets is perceived to have diminished, this declining blue sky certainly has a negative effect on the total equation.
Putting It All Together...
We hope that by providing this review of Owner’s Equity, we can motivate owners to invest in a greater understanding of not only the direct and tangible assets and liabilities but also the effect of blue sky on the potential total value of the organization. Unfortunately, determining the company’s total value is far more complicated than calculating Owner’s Equity but figuring out what you own, in tangible terms, is a great starting point. From there, a quick SWOT exercise could be beneficial to help you gain a greater understanding of the intangible value your organization offers to the marketplace.
If you have questions or want additional guidance on how to determine your Owner’s Equity, please reach out to Archimedes C&C. We are here to help you!