Equity is the residual. If you added up everything the business owns (assets) and subtracted everything it owes (liabilities), what's left is equity. It represents the cumulative value built in the business over time.
What builds equity
Equity grows when: the business earns profit and doesn't distribute it all (retained earnings accumulate), the owner contributes additional capital, or assets appreciate. Equity shrinks when: the business operates at a loss, the owner takes distributions larger than current profits, or liabilities grow faster than assets.
Equity and distributions
When you take a draw or distribution, it comes directly out of equity. Greg Crabtree's Four Forces of Cash Flow framework puts distributions last — after taxes, debt elimination, and core capital reserves — for exactly this reason.
Equity on the balance sheet
Owner's equity typically includes initial capital contributions, retained earnings (accumulated profits not distributed), and the current year's net income. For businesses that have been operating a while, retained earnings can be the largest component.
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