The Relationship Between Net Income And Owner’s Equity
Net income can be viewed as the difference between what is earned and the expenditure. Owner’s equity is the difference between the company’s assets and liabilities. This is the share that the owners would get if the company became wound up. The relationship between net income and owner’s equity is through retained earnings.
This refers to the amount that’s left after deducting the cost of goods, the operating expenses and non-operating ones from the total revenues earned. Operating expenses include marketing, administration, and rent. Non-operating expenses include interest and taxes. To ensure success in a company, one has to find ways to grow the revenue, reduce the costs and increase the net income. Execution problems and competitive pressures usually lead to declining revenues and profits.
The retained earnings account accumulates the portion of the company’s net income that it does not distribute to shareholders as cash dividends. The accounting process involves transferring or closing the revenue and expense accounts at period end to a temporary income summary account. After subtracting dividends, the balance in this account is added to the starting retained earnings for the period. The ending retained earnings balance is higher if the net income is positive and lower if the net income is negative or a loss.
This refers to total amount of the owner’s contributions, retained earnings less the cash withdrawals. The corresponding term for corporations is “stockholders’ equity,” which is the sum of the proceeds from issuing stock and retained earnings. The owner’s equity increases after the company makes a profit and retains part of it after paying out the dividends. The owner could invest more cash into the operations, sell off the excess assets in an aim to raise more cash or freeze all assets and shut down the company.
The owner’s equity is usually a company’s book value. The market value could be higher or lower than this book value. The market value is higher when investors are optimistic about a company’s prospects for growing revenues and net income. The market value is lower when weak economic and industry fundamentals lead to expectations of flat or lower net income.
If a company’s annual revenues are $5 million and its cost of goods sold is $1 million, the gross profit is $4 million. If operating and non-operating expenses are $2 million, the net income is $4 million minus $2 million, or $2 million. If the company pays dividends of $1 million to shareholders, the retained earnings are $2 million minus $1 million, or $1 million. Therefore, the owner’s equity or stockholders’ equity would increase by $1 million