The best way to define shareholder equity is the total amount of ownership investment in a particular company. It will appear as an account on the firm’s balance sheet and usually consists of common stock, paid-in capital, and retained earnings.
Key Takeaways
- Shareholder equity is the total amount of ownership investment in a company.
- You can calculate shareholder equity by subtracting all liabilities from a company’s assets.
- Negative shareholder equity means a company’s liabilities are more than its assets, which may put it in a perilous position.
- A statement of shareholder equity summarizes the ownership of a company and enables investors to see how it is being funded.
- A shareholder equity ratio of 50% is seen as a positive.
Shareholder equity reveals a company’s net worth and is particularly interesting to investors who know what amounts would be returned to shareholders once all debts have been paid off.
There are different types of shareholders equity. The first is positive shareholder equity. This is when the assets of a company are greater than its liabilities.
But what is negative shareholder equity? This is when a company’s liabilities exceed its assets and is obviously not a healthy position for the business to find itself in.
Obviously, a negative position isn’t sustainable over the long term, which is why it’s useful to understand a firm’s net worth.
When we’re looking at how shareholders equity is explained, a key element will be seeing how it’s actually calculated.
There are a number of elements that come into play.
Firstly, there needs to be a full list of the company’s total assets. This will include everything from equipment, inventory, vehicles, and furniture.
Then, you need to consider the company’s liabilities. This will include both current and long-term liabilities so that you understand how much the business needs to pay to others.
Shareholder equity, therefore, is calculated by taking the company’s total assets and subtracting the total liabilities.
A statement of shareholder equity is a calculation that has been obtained from a company’s balance sheet.
Although it’s not regarded as a required financial statement, unlike the balance sheet, its aim is to summarize the ownership of a company.
Shareholder Equity Formula
A simple formula for calculating shareholder equity is:
Shareholders’ Equity = Assets – Liabilities
There is also another calculation that is used and that is the shareholder equity ratio.
This shows how much of a company’s assets are funded by issuing stock, as opposed to borrowing money.
It’s calculated by dividing the shareholders’ equity figure by the total assets. A low ratio figure means the company has taken on more debt to finance its assets.
Return on Equity
Shareholders’ equity is also used to work out a company’s return on equity (ROE), another measure of a firm’s performance.
This is calculated by dividing net income by shareholders’ equity.
We have already highlighted two distinct forms of shareholder equity: positive and negative. In the box below, we look at the key characteristics of each approach.
- Value of assets greater than liabilities
- This is good for potential shareholders
- Money left for shareholders if liabilities paid
- It means the company is in a strong position
- Value of liabilities greater than assets
- This is a red flag for potential shareholders
- Nothing is left for shareholders if liabilities paid
- The company is in a dangerous position
Retained Earnings
Retained earnings are profits that a company decides to keep to one side to enable management to invest in the business. They won’t be paid out as dividends.
It’s very important that a firm has access to retained earnings in order to grow and develop the overall business. They can also be referred to as earnings surplus.
You can establish what is shareholder equity on the balance sheet by examining a company’s financial statements.
Here is an example from US technology giant Microsoft’s balance sheet. It shows elements such as common stock, paid-in capital, and retained earnings.
The two columns to the right of the chart below illustrate the numbers for the full year 2022 (in bold) and for the full year 2021, with both correct up to June 30 in the respective years.
Here, we look at the pros and cons of shareholder equity. The reality is that there are many positives but hardly any negatives to considering the measure.
- It enables you to gauge the financial health of a company
- Shows you how much shareholders could receive if debts are paid off
- Illustrates whether it makes sense to invest in the business
- It shouldn’t be used in isolation as it’s only one financial measure
- Negative shareholder equity is a red flag for investors as it shows a company’s liabilities are greater than its assets
- A high shareholder equity ratios means a company has financed most assets with equity capital. This can be more expensive than debt and requires dilution of ownership
The Bottom Line
There are many ways to establish a company’s financial health, but the most accurate shareholder equity definition is that it’s a way of showing ownership investment in a business.
Equity holders are always last in line to get paid when a company goes bust so it’s useful to know as much as you can about its financial position.
For example, a negative shareholder equity position illustrates that investors won’t see anything at all if the business fails. A positive position, meanwhile, means there will be something left.