A company's financial statement comprises three key elements: assets, liabilities, and shareholders' equity. A company's financial health may be evaluated using these factors, making it more straightforward for investors to assess its long-term viability.
Let's find out more about the third element or shareholder equity. Keep on reading.
We shall go into more detail about shareholder equity, including shareholder's equity meaning, its calculation, and its components in this article. Let's get going.
What is Shareholder's Equity?
A given company's net value, which one can calculate from the remaining assets that its shareholders could claim after all of its debt has been paid off, determines how much shareholder equity (SE) a company possesses. It is calculated by subtracting the total liabilities of a business from its total assets.
In this aspect, a company's retained earnings are likewise covered by the shareholder's equity. Retained earnings aren't distributed to shareholders as dividends; they're reinvested to fuel the business' expansion.
Therefore, it is essential to distinguish between a company's shareholder value and its liquidation value. This is because a company's physical assets are valued less during liquidation, and other special circumstances are also taken into account.
Comparing Positive and Negative Shareholder Equity
Shareholders' equity could be positive or negative. If the shareholder's equity is positive, the company's assets are higher than its liabilities. A negative shareholder's equity indicates that a company has more liabilities than assets.
If a company's shareholder equity continues to be negative, the phenomenon is termed balance sheet insolvency.
Retained earnings are also a component of shareholder equity, as mentioned above. It is crucial to distinguish retained earnings from cash and other liquid assets. This is because retained earnings over the years could be used for either expenses or any asset kind to expand the company.
Liquidation value is not the same as shareholder equity. Physical asset values decrease during liquidation, and other extreme circumstances prevail.
For this reason, many investors think it's risky or unsafe to invest in companies with low shareholder equity. You cannot always determine a company's financial health by shareholder equity alone.
The investor can accurately evaluate the condition of a company when Shareholder Equity is combined with other tools and data. To further grasp what shareholders' equity means, let's understand how you can calculate it.
Calculating Shareholders' Equity
When assets are liquidated, and you pay off the debts, shareholders' equity represents the owner's claim. There are two shareholder's equity formulas that you can use:
Formula 1:
Shareholders' Equity = Total Assets – Total Liabilities
The above formula, the basic accounting equation, is simple to apply. Add up all the assets on the balance sheet, then subtract the value of all the liabilities.
The sum of current assets—including marketable securities and prepayments—and long-term assets—including equipment and fixtures— comprise a company's total assets. The sum of current and long-term liabilities is a company's total liability.
The balance sheet of a company contains all of these values. The value that shareholders would receive if the company's assets were liquidated and all outstanding debts were settled is what remains after total liabilities are subtracted from total assets.
Formula 2:
Shareholders’ Equity = Retained Earnings + Share Capital – Treasury Stock
The share capital formula is sometimes referred to as the investor's equation. The business's share capital and retained earnings are added to this formula, and the treasury shares are subtracted.
Retained earnings, which are listed in the shareholders' equity portion of the balance sheet, represent the total cumulative earnings of the company after dividend payments.
Shares of the corporation retained for eventual resale to investors are repurchased as "treasury stocks." It is the difference between shares of a company that are now outstanding and those that are being offered for subscription.
The Shareholder Equity Components
There are four components used in the computation of shareholders' equity. They include:
Additional paid-in capital
The sum spent on stocks purchased for more than their declared par value is called additional paid-in capital. By deducting each common or preference share's par value from the price it was sold for, the owners' equity portion for this is calculated. The additional paid-in capital is only considered when an investor buys their shares directly from a company.
Outstanding shares
This term is used to describe shares sold to stockholders but not repurchased by the company. It includes shares that have been given to firm executives, shareholders, insiders, and the like.
So, the par value of issued common stocks and the par value of issued preferred shares that a company sells are represented by the outstanding shares.
Treasury stock
The term "treasury stock" describes shares a business has acquired from its stockholders. Most companies keep their stock in their treasury to be sold off in the future to raise finance or fend off hostile takeovers.
Repurchasing shares lowers a company's shareholders' equity, which is reflected as a negative number in the equity part of the balance sheet.
Retained earnings
Retained earnings are the portion of a company's profit kept in-house rather than being distributed as a dividend to its shareholders. A corporation's retained earnings might be used to settle debts or invested in the company.
Retained earnings can be seen on a company's balance sheet under shareholders' equity and used to calculate its retention ratio. Investors can learn more about a company's financial management by examining these four factors used to assess shareholders' equity.
Conclusion
The most crucial factor in calculating an equity investor's return on investment may be shareholders' equity. Investors should therefore consider shareholder's equity in addition to other relevant metrics to have a comprehensive understanding of a company's financial situation.
We are confident that after reading this article, you now know everything you need to know about shareholder equity.