The Relationship Between Net Income and Owner's Equity

By Motley Fool

The more money a business takes in, the more money its owners are likely to make. A company's net income therefore plays a significant role in determining owner's equity.

Net incomeNet income is calculated by taking a company's revenues for a given period of time and subtracting the cost of goods sold. The cost of goods sold includes all the expenses involved in doing business, such as rent, payroll, equipment, advertising, and taxes.

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Owner's equityOwner's equity is the business's assets minus its liabilities. It is listed on a company's balance sheet. Owner's equity is often referred to as the book value of a company, which can differ from its market value. There are factors other than those accounted for on a balance sheet that can influence a company's market value, for better or worse. If a company is showing signs of growth, its market value might exceed its book value. On the other hand, if the company is part of a dying industry, then its market value might be lower than its book value.

How net income affects owner's equityNet income contributes to a company's assets and can therefore affect the book value, or owner's equity. When a company generates a profit and retains a portion of that profit after subtracting all of its costs, the owner's equity generally rises. On the flip side, if a company generates a profit but its costs of doing business exceed that profit, then the owner's equity generally decreases.

However, net income is only one factor that can affect owner's equity in a company. Owner's equity can also increase if the owner of a businessinvests more money into the business. Similarly, it can decrease if the owner takes money out of the business.

Let's say a company brings in revenue of $3 million in a given year, and its total cost of doing business is $2 million. In this case, the $1 million in retained earnings is its net income for the year, and that $1 million becomes part of the company's total assets. If the company's liabilities remain completely unchanged from the previous year, then the additional $1 million in net income will increase the owner's equity by $1 million.

Now let's say that same $3 million in revenue is wiped out by $3 million in operating costs, resulting in zero net income. If the company's liabilities remain completely unchanged from the previous year but an independent investordecides to put $100,000 into the business (which is a private company, not a public one), then the owner's equity will increase by $100,000 even if there's no net income recorded.

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