Stockholder equity refers to the total assets remaining for the shareholders after all liabilities have been paid. It can be easily derived by subtracting a company’s total liabilities from its assets. Stockholder equity, also known as shareholder equity, can include retained earnings, paid-in capital, common stock, and treasury stock.
The concept of stockholder equity is important to judge the funds that a business retains. Negative stockholder equity can be a sign of impending bankruptcy, especially in cases where the company is already under substantial debt.
In this article, we will discuss the crucial concept of stockholder equity, learn how to calculate it and how it works, and understand its relationship with a few related concepts.
How to calculate stockholder equity?
If you know the total assets and total liabilities of a company, calculating the stockholder equity becomes easy. The formula for it is given below:
Stockholder equity = Total assets - Total liabilities
The essential information needed to calculate shareholder equity can be found on the balance sheet of the given company. The total assets include”
Current assets
Simply put, current assets refer to those assets of a company which are high in liquidity and can be converted into cash in a year. Typically, cash, inventory, and accounts receivable are considered current assets.
Non-current assets
These are long-term assets that cannot be easily converted into money or fully consumed in a year. They include investments and intangibles like equipment, plants, property, patents, and so on.
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In a similar vein, total liabilities also include long-term and current liabilities. Here:
- Current liabilities usually refer to debt and loans which have to be repaid in a year.
- Long-term liabilities do not have to be repaid so quickly and can be of varying value. These include leases, bonds payable, and obligations of pension.
How stockholder equity works
Stockholder equity can also be called the book value of a company. This is derived from two major sources:
- Money invested by shareholders through share offerings.
- Retained earnings accumulated from the company's operations over time.
Retained earnings (RE) typically form a major chunk of stockholder equity, especially for more established companies.
What is key to note is that shareholder equity can be either positive or negative. When it is positive, it indicates that a company has sufficient assets to pay off liabilities. However, if the shareholder equity is negative, it means that the liabilities of the company have exceeded its assets. If the same situation continues for a long time, it can be termed balance sheet insolvency. This is why investors generally consider companies with negative shareholder equity a risky investment. Even though it is not the sole indicator of the financial health of a company and must be used in conjunction with other metrics, it is relied on by a large number of traders in the market.
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Stockholder equity and retained earnings
Retained earnings are the company's profits that are kept as additional equity instead of being distributed as dividends. They are part of stockholders' equity and represent the reinvested returns.
RE is part of the income statement of a company and grows over time as the business matures. Eventually, retained earnings can exceed the contributed equity capital and become the main component of stockholders' equity.
Stockholder equity and paid-in capital
In general, businesses finance their large capital purchases through borrowed capital and equity. Thus, shareholder equity is also considered a part of the firm’s net assets. As stockholders, investors contribute to the paid-in capital, which becomes a primary part of the stockholder equity.
Investors contribute money to a company by purchasing shares, known as paid-in capital. This paid-in capital is the primary source of stockholders' equity. The amount of money each investor puts in determines their ownership percentage in the company. This investment helps the company grow while providing investors with returns through dividends and increased share value.
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Stockholder equity and the impact of treasury shares
When companies are unable to fully utilise their equity capital to generate desired profits, they can return some of it to stockholders through share buybacks. In this process, the company buys back its own shares, which then become treasury shares. These shares are recorded in a special account called the treasury stock contra account.
A key feature of treasury shares is that they are still considered issued but not outstanding, so they do not receive dividends or count in earnings per share calculations. In the future, these companies have the option to reissue the treasury shares if they intend to raise more capital from the market. On the flip side, a company may want to retire the shares permanently if it does not intend or plan to use them anytime in the future.
Conclusion
Stockholder equity is a crucial financial metric that calculates the remaining assets for shareholders after all liabilities are paid. It encompasses retained earnings, paid-in capital, common stock, and treasury stock. Calculating stockholder equity involves subtracting total liabilities from total assets, which can be easily found on a company's balance sheet. Understanding stockholders' equity helps assess a company's financial health and investment potential. Positive equity indicates sufficient assets to cover liabilities, while negative equity suggests financial instability. This metric, though not the sole indicator, is a key factor for investors in evaluating a company's worth and stability.
