Periodically reevaluating basic business elements can help business owners improve their companies and increase their value. One significant component is owner’s equity (or stockholders’ equity or partner capital accounts). As the “net assets” of a business, it is important for business owners to understand the return they are earning from these assets.
In its simplest terms, owner’s equity is the difference between a business’s assets and its liabilities. It is also referred to as a company’s net assets or its book value, and unless the business’s assets were recently purchased, generally reflects cost versus market values and may exclude intangible assets and intellectual property. Generally, a company is worth at least its net asset value, but in cases of appreciated assets and/or strong cash flow, it can be worth substantially more. Therefore, net assets often reflect a conservative view of the net amount of money or owner capital employed in a business.
It’s important to think of equity or net assets as real money, as indicated by the dollar symbol in front of the owner’s equity category on the balance sheet.
When net assets (owner’s equity) is viewed as money, or as an investment, versus a balance sheet item, it is easier to focus on an important question: What income is the business generating from its investment/net assets? Since small businesses are often central to the financial well-being of their (family) owners, it is important for owners to understand how their investment is performing.
Going a step further, how is this investment performing in comparison to the owner’s other investments? For example, how does the return on the business investment compare to the owner’s stock and bond portfolio? Is the owner expecting a 7-9% annual return on the traditional investment portfolio, while accepting a return of 2-4% from the equity invested in the business?
Since performance is related to how well a business is being managed, can the underlying business be managed better so that its return can be increased? If not, are there excess business assets (or even the entire company) that could be sold and invested in a better performing investment? Alternatively, if the business is performing extremely well, can additional capital be deployed in it at this higher rate of return?
One way to evaluate performance is to compare the return of the business to similar businesses. This can be done by benchmarking, which is essentially obtaining and comparing return information for other companies in the same or similar industries.
A quick way to get a feel for a business’s return is to determine its return on equity. This is simply net income divided by owner’s equity:
You can refine this calculation by using the average owner’s equity balance during the year. If the market value of the assets is much higher than the book value, for instance, the business is sitting on assets that cost much less than their current value (e.g., real estate or investments), or the balance sheet includes liabilities that are shown at higher amounts than the business might have to pay, the return on equity might be over or understated. For example, a net income of $100,000 on $1,000,000 of net assets equals a 10% return on equity. However, if there has been substantial appreciation in certain assets and the market value of the net assets is actually $2,000,000, then the return on equity, based on market values, is really 5%.
In summary, equity or net assets reflect a conservative view of the owner’s investment in a business and should be regarded as “real money.” By periodically checking a business’s return on equity, a business owner can measure and compare the return to his/her other investments, as well as other similar businesses. The results can help business owners take corrective action or other steps to improve the business and the owner’s overall return.
James Hart, MBA, CPA, CIRA, founder of Lightfoot Group, LLC assists private and family-owned businesses with business troubleshooting services including: significant business challenges, management and ownership transitions and interim management. He can be reached at firstname.lastname@example.org and at 678-320-0079. This article is designed to provide general information and is not intended to provide specific legal, accounting, tax or other professional advice. You should consult your professional advisors for assistance with respect to any matter discussed in this article.
© 2018 James F. Hart, Lightfoot Group, LLC