Basically, stockholders’ equity is an indication of how much money shareholders would receive if a company were to be dissolved, all its assets sold, and all debts paid off.
Types of Stockholders’ Equity
There are two types of stockholders’ equity:
Paid-in capital, also referred to as stockholders’ funds, is the amount of money that people have invested in a company. This type of equity can come from different sources, including issuing new shares or converting debt to equity.
The amount of paid-in capital that a company has is directly related to the total stockholders’ equity that it displays. This makes sense as the company’s total stockholders’ equity is the cumulative amount of paid-in capital and retained earnings.
Retained earnings are the profits that a company has earned and reinvested in itself instead of distributing it to shareholders. This is where the value of stockholders’ equity comes from.
For example, if a company made $100 million in annual profits, but only paid out $10 million to shareholders, its retained earnings would be $90 million.
Retained earnings grow in value as long as the company is not distributing them to shareholders and only investing them back into the business.
Steps to Calculate Stockholders’ Equity
There are two steps to calculate stockholders’ equity.
1) Subtract liabilities from assets. This is usually done on a company’s balance sheet.
2) Add any additional paid-in capital (such as issuing new shares or debt conversions, etc.) and subtract any additional paid-in capital (such as issuing new shares or debt conversions, etc.).
The formula is as follows:
This formula can be translated as such:
This is what makes up a company’s total stockholders’ equity. The value of their assets minus the value of their liabilities.
How Does the Balance Sheet Show the Amount of Stockholders’ Equity?
The balance sheet is a financial statement that lists the assets, liabilities, and stockholders’ equity accounts of a business at a specific point in time.
As referred above, stockholders’ equity can be calculated by taking the total assets of a company and subtracting liabilities.
For example, if a company has assets of $15,000 and liabilities of $10,000, its stockholders’ equity would be $5,000.
Every accounting period, there are entries on the balance sheet that indicate an increase or decrease in this figure.
In practice, most companies do not list every single asset and liability of the business on their balance sheet. Rather, they only list those accounts that are relevant to their situation.
For example, if a company does not have any non-equity assets, they are not required to list them on their balance sheet.
Often, this summary is accompanied by income statements and cash flow statements to provide a full picture of the company’s financial situation.
What Happens When There Is Not Enough Cash Flow or Assets On Hand to Cover Liabilities?
If a company does not have enough cash flow or assets to cover their liabilities, they are in what is known as “negative equity.”
Negative equity can arise if the company has negative retained earnings, meaning that their profits were not strong enough to cover expenses.
For example, it is possible for a company to have $1 million in assets and $2 million in liabilities, but still, be unprofitable. This will result in negative retained earnings because the company’s net income was $1 million less than its expenses.
Negative equity can also occur when there is not enough money realized from sales to cover the company’s debt obligations.
For example, if a company has $3 million in fixed asset obligations, but only made $2 million in profit for the year, it cannot cover its fixed assets with its profits.
If the above situation occurs, stockholders’ equity would be negative and it would be difficult for the company to raise more capital.
Why Is It Important for a Company to Have Enough Stockholders’ Equity?
Stockholders’ equity is important for a company because it demonstrates the amount of money that would be available to either pay off liabilities or reinvest in the business.
If a business has more liabilities than assets or does not have enough stockholders’ equity to cover its debt, then it will need to turn to outside sources of capital. This is often done by either borrowing money or issuing shares of stock, both of which can result in additional obligations.
Also, if shareholder equity is positive, it typically shows that the business is strong, which can lead to the company being able to raise capital on better terms.
Common Misconceptions About Stockholders’ Equity
One common misconception about stockholders’ equity is that it reflects cash resources available to the company.
Cash takes up a large portion of the balance sheet, but cash is actually not considered an asset because it is expected that cash will be spent soon after it comes into the business.
Another misconception about stockholders’ equity is that it represents the company’s owner or shareholder equity.
While this figure does include money that could be returned to the owners of the company, it also includes items like depreciation and amortization, which cannot be directly distributed to shareholders.
Wrap – Up
Stockholders’ equity is a financial indicator that reflects the value of the assets and liabilities on a company’s balance sheet.
The exact calculation and total depends on what is included as an asset and liability, but it always represents the amount of money available to the business, either to pay off liabilities or reinvest in its operations.
Overall, this article provides readers with a detailed definition of stockholders’ equity along with the most common misconceptions about the value. It also highlights how this figure can play an important role in determining whether or not a company has enough capital to meet its financial obligations.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.