From an accounting viewpoint, the amount of money that owners invest in a company is that company’s equity. Equity is made up of different parts. Some of it comes from the money owners put directly into the company, and some of it comes from the profits the company makes. Two key components of equity are paid in capital and earned capital.
To operate your business, you need all sorts of things -- from inventory to premises to equipment to machinery; the list goes on depending on your business type and industry. You also need financing sources to pay for these assets, and a prime source of financing comes from investors. When investors invest money in your company they become owners of the business by acquiring equity in it. In return for investing their money, investors get stock or share in your company.
Paid In Capital
Often, when a company needs financing, it issues shares. Each share has a face, or par, value. Your company’s shares will be in high demand if investors believe its share value will increase in the future. In this case, the amount that investors pay per share may exceed the par value. Paid in capital is the difference between the cost of the shares at par and the actual price that investors paid for them.
When a business generates more revenue than the costs it incurs, it makes money. The accounting term for that difference is net income. However, net income is not a certain amount of money that you associate to an account by that name in your books. It is the difference between revenues and costs along a certain period, such as a month, a quarter or a year. Usually, when a company makes profits, it distributes dividends, a portion of its net income, to its shareholders.
Also called retained earnings, earned capital is the portion of net income that companies choose not to distribute as dividends. Instead, they add it to equity. Companies typically do not distribute all of their net income in dividends. This means that equity, through earned capital, will usually increase when a company makes profits. If, for example, your company chooses not to distribute dividends at all, you will add the net income to equity, increasing earned capital by that amount. Conversely, if your company, experiences a loss instead of making a profit, your earned capital, and therefore, equity, will be reduced by the amount of the loss, and you and your fellow owners will suffer a proportionate decrease in your wealth.