What is Equity in Accounting?

I’ll never forget the day a client walked into my office, beaming with pride about his “profitable” business, only to discover minutes later that he was technically insolvent. His bank account showed healthy activity, his sales were growing, but his equity told a completely different story—one he’d never learned to read.

He’s not alone. Over my ten years as a Chartered Accountant working with small businesses and startups, I’ve seen this confusion play out hundreds of times. Business owners obsess over revenue and profit (and they should), but equity? That quietly sits on the balance sheet, misunderstood and ignored, even though it’s arguably the most important number that defines your business’s true financial health.

If you’ve ever looked at your balance sheet and felt lost, or wondered what equity actually means for your day-to-day operations, you’re in the right place. By the end of this guide, you’ll understand not just what equity is, but how to track it, improve it, and use it to make smarter business decisions. No accounting degree required—just fifteen minutes and an open mind.

 

So, What Exactly Is Equity in Accounting?

Here’s the simplest way I explain it to every business owner who asks: Equity is what you truly own in your business after you’ve paid off everything you owe.

 

Think of it like your house. If your home is worth ₹50 lakhs and you still owe ₹30 lakhs on your mortgage, your actual ownership—your equity—is ₹20 lakhs. Same concept, different context.

In accounting terms, we use this fundamental formula:

Equity = Total Assets – Total Liabilities

Your assets are everything your business owns (cash, inventory, equipment, accounts receivable). Your liabilities are everything you owe (loans, unpaid bills, credit card debt). What’s left after subtracting liabilities from assets? That’s your equity—your true stake in the business.

For sole proprietors and partnerships, we call this owner’s equity. For corporations, it’s stockholders’ equity or shareholders’ equity. The names differ, but the concept remains the same: it’s the residual value that belongs to the owners after all debts are settled.

Now, let me show you why this matters more than you might think.

 

Why Should You Care About Equity? (Spoiler: It’s Your Financial Health Report Card)

When I started advising small businesses back in 2012, I noticed a pattern. The owners who regularly tracked their equity made better decisions. They knew when to reinvest profits, when to take money out, and when to hit the brakes on expansion.

Here’s why equity deserves your attention:

It Shows Your True Financial Position

Revenue is vanity. Profit is sanity. But equity? Equity is reality.

You can have ₹10 lakhs in monthly sales and still be drowning in debt. Your profit and loss statement might show a healthy bottom line this quarter, but if your liabilities have been silently growing faster than your assets, your equity tells that story.

According to recent SBA data, businesses with positive equity are 40% more likely to secure bank loans than those with negative equity. Lenders don’t just look at your income—they want to see that you have real skin in the game, real ownership value that proves sustainability.

 

It Guides Your Decision-Making

Last year, I worked with a small manufacturing startup. The founder wanted to buy new equipment worth ₹15 lakhs. On paper, he had the cash flow to make the purchase. But when we looked at his equity, we discovered he’d been drawing too much from the business. His equity had shrunk by 30% in six months.

We paused the equipment purchase, focused on rebuilding equity through retained earnings, and six months later, he made that investment from a position of strength rather than vulnerability. That’s the power of tracking equity—it forces you to look beyond immediate cash and consider long-term stability.

 

It Attracts Investors and Partners

If you’re a startup looking for funding, equity structure is everything. Investors don’t just want to see revenue projections—they want to understand your current equity position, how it’s distributed among founders, and what their investment will actually buy them.

A 2022 QuickBooks report found that over 70% of startups use equity financing as their primary funding source. Whether you’re talking to angel investors or venture capitalists, they’re evaluating your equity to determine business health and ownership dilution.

 

It Reveals Problems Early

Negative equity is like a fever—it’s not the disease itself, but a symptom that something’s seriously wrong. If your liabilities exceed your assets, you’re technically insolvent, even if you’re still operating.

I’ve seen businesses run for months with negative equity, owners unaware they’re one bad month away from collapse. Catching this early through regular equity monitoring can be the difference between a course correction and a shutdown.

 

How Does Equity Actually Work in Practice?

Let me walk you through a real example (details changed for privacy, but the numbers are real).

Meet Priya. She runs a small retail business in Bangalore selling home décor items. Here’s her situation:

Assets:

• Cash in bank: ₹45,000
• Inventory: ₹60,000
• Shop equipment: ₹15,000
• Total Assets: ₹1,20,000

Liabilities:

• Supplier credit: ₹25,000
• Business loan: ₹20,000
• Total Liabilities: ₹45,000

Equity = ₹1,20,000 – ₹45,000 = ₹75,000

So Priya truly owns ₹75,000 worth of her business. That’s her equity.

But here’s where it gets interesting. Equity isn’t static—it changes constantly based on your business activities.

 

How Equity Increases

• You invest more money (capital contribution)
• Your business makes a profit and you keep it in the business (retained earnings)
• Your assets grow in value (like equipment or inventory appreciation)

 

How Equity Decreases

• You withdraw money for personal use (drawings or distributions)
• Your business loses money (expenses exceed revenue)
• Your liabilities increase faster than your assets

Let’s continue with Priya’s story. Over the next quarter:

• She earned ₹25,000 in net profit
• She withdrew ₹10,000 for personal expenses
• Her ending equity: ₹75,000 + ₹25,000 – ₹10,000 = ₹90,000

This movement is what we track in an owner’s equity statement—a simple report showing how equity changed over time. And honestly? Every business owner should review this quarterly, minimum.

 

What Are the Main Components of Equity?

Equity isn’t just one number—it’s made up of different pieces that tell different parts of your business story.

 

For Sole Proprietors and Partnerships: Owner’s Equity

This includes:

Capital Contributions: Money you put into the business from your own pocket. When Rajesh started his consulting practice, he invested ₹2 lakhs of personal savings. That’s his initial capital.

Retained Earnings: Profits you’ve earned and kept in the business rather than withdrawing. If you made ₹50,000 profit last year and left ₹40,000 in the business account, that ₹40,000 becomes retained earnings, increasing your equity.

Drawings/Withdrawals: Money you take out for personal use. These reduce your equity. If you withdraw ₹15,000 per month for living expenses, that’s ₹1.8 lakhs annually coming out of your equity.

The formula for owner’s equity movement:

Ending Capital = Beginning Capital + Net Income – Drawings

For Corporations: Stockholders’ Equity

This gets a bit more complex because ownership is divided into shares:

Common Stock: The par value of shares issued to founders and investors. If you issued 10,000 shares at ₹10 par value, that’s ₹1 lakh in common stock.

Additional Paid-in Capital: Money investors paid above the par value. If someone bought those ₹10 shares for ₹50 each, the extra ₹40 per share goes here.

Retained Earnings: Same concept—accumulated profits kept in the business rather than distributed as dividends.

Treasury Stock: Shares the company bought back from shareholders (this reduces equity).

I’ve worked with startups that completely botched their equity structure because they didn’t understand these components. One founder issued shares at ₹1 par value to early investors, then tried to issue shares at ₹100 to later investors without understanding the dilution implications. Messy situation.

 

How Do I Actually Calculate and Track My Equity?

Good news: if you’re maintaining even basic accounting records, calculating equity is straightforward.

 

Step 1: Know Your Assets

List everything your business owns:

• Cash and bank balances
• Accounts receivable (money customers owe you)
• Inventory
• Equipment and machinery
• Vehicles
• Property (if owned)
• Prepaid expenses
• Investments

Be realistic. Your five-year-old laptop isn’t worth what you paid—use current fair value.

 

Step 2: Know Your Liabilities

List everything you owe:

• Bank loans
• Credit card debt
• Supplier credit (accounts payable)
• Outstanding taxes
• Employee salaries due
• Loans from friends/family
• Lease obligations

Include everything, even that ₹20,000 you borrowed from your brother-in-law.

 

Step 3: Do the Math

Subtract total liabilities from total assets. That’s your current equity.

 

Step 4: Track Changes Quarterly

Create a simple spreadsheet or use accounting software (more on that in a moment) to track:

• Beginning equity
• Capital added
• Net profit/loss for the period
• Withdrawals taken
• Ending equity

Here’s a real example from a client’s quarterly equity statement:

Q1 2024 Equity Statement:

• Beginning equity (Jan 1): ₹5,60,000
• Add: Net income: ₹1,80,000
• Add: Additional capital invested: ₹50,000
• Less: Owner withdrawals: ₹90,000
• Ending equity (Mar 31): ₹7,00,000

That’s a healthy 25% growth in equity over three months—a sign the business is building real value.

 

What’s the Difference Between Equity and Other Financial Terms?

I get asked this constantly, so let’s clear up the confusion.’

Equity vs. Capital

Capital is what you invest initially or add later. Equity includes your capital plus all the profits you’ve retained minus any losses or withdrawals.

Think of capital as the seed you plant. Equity is the entire tree that grows from it.

 

Equity vs. Profit

Profit is what you earned in a specific period (usually a year or quarter). Equity is your cumulative ownership value over the entire life of the business.

You can have a profitable quarter and still see equity decline if you’re withdrawing more than you’re earning. I’ve seen this happen to seasonal businesses all the time—great summer sales, but they overdraw during winter, and equity shrinks despite annual profitability.

 

Equity vs. Net Worth

In personal finance, these are basically the same thing—your assets minus your liabilities. In business accounting, equity specifically refers to the owners’ claim on business assets, while net worth is a broader term sometimes used interchangeably.

 

Equity vs. Stock

Stock represents ownership shares in a corporation. Equity is the total value of that ownership. Stock is the vehicle; equity is the value it represents.

If you own 1,000 shares in a company with total equity of ₹10 lakhs divided into 10,000 shares, your stock represents ₹1 lakh of equity (10% ownership).

 

When Should You Review Your Equity?

Here’s my recommendation based on years of practice:

Monthly: Quick check if you’re a startup or experiencing rapid growth/change.

Quarterly: Standard review for most small businesses. This gives you time to see meaningful trends without obsessing over daily fluctuations.

Annually: Minimum requirement. If you’re only looking once a year, you’re flying blind for 11 months.

Before major decisions: Always check equity before:

• Taking out new loans
• Making large purchases
• Bringing in investors
• Considering business expansion
• Withdrawing significant amounts

I once stopped a client from buying a delivery vehicle because his equity review showed he’d been operating at a loss for two quarters—something his bank balance hadn’t revealed because of timing differences in cash flow.

 

What Are the Common Mistakes People Make With Equity?

Let me share the mistakes I see repeatedly (and have made myself early in my career):

 

Mistake #1: Confusing Cash Flow with Equity

Just because you have money in the bank doesn’t mean you have strong equity. You might have received advance payments from customers (a liability until you deliver) or taken out a loan (increases cash but also increases liabilities, potentially decreasing equity if you’re already leveraged).

 

Mistake #2: Ignoring Drawings/Withdrawals

Many sole proprietors treat their business account like a personal ATM, withdrawing irregularly without tracking. Every rupee you withdraw reduces your equity. If you’re withdrawing faster than you’re earning, you’re slowly strangling your business.

Solution: Set a fixed monthly drawing amount based on your average profits, and stick to it.

 

Mistake #3: Not Adjusting for Depreciation

Your assets lose value over time. That ₹5 lakh vehicle you bought three years ago isn’t worth ₹5 lakhs today—maybe ₹3 lakhs if you’re lucky. If you don’t account for depreciation, you’re overestimating your equity.

 

Mistake #4: Mixing Personal and Business Expenses

When you pay personal expenses from your business account without properly recording them as drawings, your books become a mess, and your equity calculation becomes meaningless.

 

Mistake #5: Forgetting About Equity When Making Growth Decisions

I’ve watched businesses expand into new product lines or locations while their equity was quietly declining. Growth without solid equity is building a house on sand.

 

Mistake #6: Not Understanding Equity Dilution

For startups issuing shares, every new investor dilutes existing ownership. If you own 100% of a company (₹10 lakh equity) and sell 20% to an investor for ₹3 lakhs, total equity becomes ₹13 lakhs, but you now own only 80% (₹10.4 lakhs). You gained cash but lost ownership percentage.

This isn’t necessarily bad—dilution can be healthy if it brings in capital that grows the overall pie. But too many founders give away equity without understanding the math.

 

How Can You Improve Your Business Equity?

Now for the practical part—how do you actually build equity?

Strategy #1: Increase Profitability

Obvious but essential. Every rupee of profit you don’t withdraw becomes retained earnings, increasing equity.

Look for ways to:

• Increase prices (even 5% can make a huge difference)
• Reduce cost of goods sold
• Cut unnecessary expenses
• Improve operational efficiency

 

Strategy #2: Reinvest Profits Strategically

Instead of withdrawing all profits, keep a portion in the business. I recommend a 60-40 split for most small businesses: withdraw 60% for personal needs, reinvest 40% to build equity.

 

Strategy #3: Reduce Liabilities Systematically

Pay down high-interest debt first. Every rupee of debt you eliminate increases your equity by one rupee (assuming assets stay constant).

Create a debt reduction plan:

1. List all debts with interest rates
2. Pay minimums on everything
3. Throw extra money at the highest-interest debt
4. Move to the next once the first is cleared

 

Strategy #4: Invest Additional Capital

When the business needs it and you have personal savings, injecting capital increases equity immediately. Just make sure you’re investing in a fundamentally sound business, not throwing good money after bad.

 

Strategy #5: Control Drawings/Withdrawals

Set a reasonable, fixed withdrawal amount based on your average profits. Resist the temptation to take extra during good months—that discipline builds equity over time.

 

Strategy #6: Monitor and Protect Asset Values

Maintain equipment properly, manage inventory efficiently, collect receivables promptly. Protecting asset values protects equity.

 

Real-World Equity Scenarios

Let me share three scenarios I’ve encountered:

 

Scenario A: The Profitable Business with Shrinking Equity

Amit ran a successful catering business with consistent monthly profits of ₹80,000. But he was withdrawing ₹1.2 lakhs monthly for personal expenses and lifestyle upgrades.

Result? Despite profitability, his equity declined 15% annually. When he needed a loan to expand, the bank rejected him because his equity trend showed financial indiscipline.

Lesson: Profit doesn’t guarantee equity growth if you’re overdrawing.

 

Scenario B: The Startup with Negative Equity

Neha launched a tech startup with ₹5 lakhs personal investment. After two years of development with no revenue, she’d burned through her capital and taken on ₹8 lakhs in debt.

Her equity: ₹5 lakhs (initial capital) – ₹5 lakhs (accumulated losses) – ₹8 lakhs (net liabilities) = -₹8 lakhs negative equity.

Technically insolvent. She needed either revenue fast or fresh investment to survive.

Lesson: Startups must monitor burn rate and equity closely. Negative equity is a ticking clock.

 

Scenario C: The Smart Equity Builder

Ravi ran a small accounting practice. He consistently:

• Reinvested 50% of profits
• Controlled withdrawals to ₹50,000 monthly
• Paid down his initial ₹3 lakh loan systematically
• Avoided unnecessary debt

Over five years, his equity grew from ₹2 lakhs to ₹18 lakhs—a 9x increase that made his practice attractive when a larger firm approached to acquire it.

Lesson: Consistent equity-building habits create valuable, saleable businesses.

 

How Does Equity Affect Business Valuation?

When you eventually sell your business or bring in partners, equity plays a central role in valuation.

Most small business valuations use a multiple of equity or earnings. A business with ₹20 lakhs in equity might sell for 1.5x to 3x equity depending on industry, growth potential, and profitability.

But here’s the thing: strong, growing equity signals a well-managed business, which commands higher multiples. Declining or negative equity scares away buyers and investors.

If you’re building a business you might someday sell, treat equity building as building your exit value.

 

Tools and Technology for Tracking Equity

Look, you can track equity in a spreadsheet. I did that for years. But honestly? Modern accounting software makes this so much easier.

With tools like ProfitBooks, your equity is calculated automatically from your daily transactions. Every invoice you create, every expense you record, every payment you receive—it all flows through to your balance sheet, updating your equity in real time.

You get instant visibility into:

• Current equity position
• Equity trends over time
• Components of equity (capital, retained earnings, drawings)
• Balance sheets that show assets, liabilities, and equity clearly

No manual calculations. No spreadsheet errors. No wondering if you forgot to include something.

The best part? You don’t need an accounting background. The software handles the technical stuff while you focus on understanding what the numbers mean for your business decisions.

For small businesses and startups, this kind of automated equity tracking has been a game-changer. I’ve watched clients go from quarterly equity reviews (because manual calculation was tedious) to checking equity weekly because it’s just… there, updated and accurate.

 

Frequently Asked Questions About Equity

What is equity in accounting for a small business?

Equity is your ownership value in the business—what you’d have left if you sold all assets and paid off all debts. It’s calculated as total assets minus total liabilities and represents your true financial stake.

How do I calculate owner’s equity?

Subtract your business liabilities from your assets. For example, if you have ₹1 lakh in assets and ₹40,000 in liabilities, your owner’s equity is ₹60,000. Track changes by adding profits and capital contributions, then subtracting losses and withdrawals.

What’s the difference between owner’s equity and stockholders’ equity?

Owner’s equity applies to sole proprietorships and partnerships—it’s your personal ownership stake. Stockholders’ equity is used in corporations and represents the collective ownership of all shareholders through issued stock. Same concept, different business structures.

Can equity be negative? What does that mean?

Yes, negative equity means your liabilities exceed your assets—you owe more than you own. This signals serious financial trouble or insolvency risk and can make it nearly impossible to secure financing or attract investors. It requires immediate corrective action.

How does equity affect my ability to get a loan?

Lenders view strong, positive equity as a sign of financial health and lower risk. Research shows businesses with positive equity are 40% more likely to secure loans. Negative or declining equity raises red flags about your ability to repay.

What’s an owner’s equity statement?

It’s a financial report showing how your equity changed over a specific period. It starts with beginning equity, adds profits and capital contributions, subtracts losses and withdrawals, and ends with your current equity. Think of it as a movement schedule for ownership value.

How often should I review my equity?

Quarterly reviews work for most small businesses, giving you time to spot meaningful trends. Monthly reviews make sense if you’re growing rapidly or experiencing changes. At minimum, review annually and always before major financial decisions like loans, investments, or large purchases.

How does issuing new shares affect equity?

Issuing shares increases total equity (you’re bringing in capital) but dilutes existing ownership percentages. If you own 100% and sell 20% to an investor, you now own 80% of a larger pie. The key is ensuring the new capital grows the business enough to offset the dilution.

What’s the difference between equity and profit?

Profit is what you earn in a specific period (like a quarter or year). Equity is your cumulative ownership value over the entire life of the business, including all past profits you’ve retained, capital you’ve invested, and drawings you’ve taken. Profit is a flow; equity is a stock.

How can I improve my business equity quickly?

Focus on three levers: increase profitability (grow revenue or cut costs), reduce liabilities (pay down debt), and control withdrawals (reinvest more profits instead of taking them out). Even small improvements across all three create significant equity growth over time.

 

Your Equity Is Your Business Story

Here’s what I want you to remember: your balance sheet isn’t just numbers on a page. It’s your business story, written in financial language.

Your equity is the autobiography of every decision you’ve made—every rupee invested, every profit earned and retained, every debt taken on, every withdrawal made. It’s the cumulative result of thousands of small choices about how to run your business.

And unlike revenue or profit, which can fluctuate wildly from month to month, equity shows the long-term trend. It cuts through the noise and reveals whether you’re building something valuable or slowly bleeding out.

I’ve seen businesses with modest revenues but strong, growing equity—they’re building real value. And I’ve seen businesses with impressive sales but declining equity—they’re running fast but going nowhere.

The question isn’t whether you should track equity. You absolutely should. The question is: what story will your equity tell?

 

Take Control of Your Financial Future

Understanding equity isn’t just about accounting compliance or impressing investors. It’s about taking control of your business’s financial future with clear eyes and accurate information.

Start today. Pull up your latest balance sheet (or create one if you don’t have it). Calculate your equity. Look at the trend over the past year. Ask yourself: am I building value, or am I treading water?

If the answer worries you, that’s actually good news—awareness is the first step to change. You can’t fix what you don’t measure.

And if you’re tired of wrestling with spreadsheets and manual calculations, consider using accounting software that tracks equity automatically. With ProfitBooks, your balance sheet updates in real time as you record transactions, giving you instant visibility into your equity position without the headache of manual bookkeeping.

Your business deserves better than guesswork and gut feelings. Give yourself the gift of financial clarity. Track your equity. Understand your equity. Build your equity.

Because at the end of the day, your equity isn’t just a number on a balance sheet—it’s the measure of everything you’ve worked for, the foundation for everything you’ll build, and the legacy you’ll leave behind when you’re ready to move on.

Start tracking it today. Your future self will thank you.