A company’s financial statement consists of three principal components, namely – assets, liabilities and shareholders equity. Each of these components plays an essential role in gauging the financial health of a company, making it easier for investors to determine the company’s sustainability in the long run. Following is thus an elaboration on shareholder equity, its calculation and its components for a general understanding.
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Shareholder equity (SE) is given by a company’s net worth, which is derived by way of the residual assets that can be claimed by said company’s shareholders, after all of its debt has been paid off. It is calculated by subtracting a company’s total liabilities from its total assets.
In this regard, a company’s retained earnings are also included under the purview of SE. Retained earnings are not paid out to a company’s shareholders as dividends, but are instead reinvested to propagate the company’s growth.
Nonetheless, a company’s shareholder value should not be confused with its liquidation value. It is because, during liquidation, a company’s physical asset values are reduced, and there are other extraordinary circumstances that are taken into account.
To understand the shareholders equity meaning better, the following is a look at how it is calculated.
There are a couple of formulae that can be utilised to calculate a company’s SE.
In this regard, the most widely used shareholders equity formula goes as –
SE = Total Assets – Total Liabilities
It is the basic accounting formula and is calculated by adding the company’s long term as well as current assets and subtracting the sum of long term liabilities plus current liabilities from it.
Following is a shareholders equity example using the formula above that can help simplify its meaning.
Consolidated balance sheet for Company XYZ –
|Current Assets||Dec 31st 2019 (in Rs. lakh)|
|Cash and equivalents||2340|
|Short term investments||850|
|Total current assets||6900|
|Long term assets||4600|
|Total current liabilities||7631|
|Deferred long-term liability charges||1076|
From the above balance sheet, shareholders equity calculation can be given by –
SE = Total assets – total liabilities
= Rs.(16,645 – 9906) lakh
Here are the steps to follow for calculating shareholders equity –
- Locate and calculate a company’s total assets from its balance sheet for the period.
- Locate and calculate its total liabilities.
- Subtract total liabilities from total assets to know the shareholders equity.
While the example for calculating shareholders equity mentioned above utilised the basic accounting formula, one can also use the formula given below for the purpose –
SE = Share Capital + Retained Earnings – Treasury Shares
Here, there are four components that are utilised for the shareholders equity calculation. These are –
It refers to the stocks that have been sold to stockholders but have not been repurchased by the company. It includes stocks that have been issued to company officers, public investors, company insiders and the likes.
Outstanding shares, thus, represent the par value of common stocks issued, alongside the par value of preferred shares that the company sells.
Additional paid-in capital
Additional paid-in capital is the amount that is paid for stocks that are above their stated par value. This component of shareholders equity is computed by subtracting the par value of each common or preference share, from the value they have been sold for. The additional paid-in capital is taken into consideration only when an investor purchases shares directly from the company.
Retained earnings refer to the amount that is retained from a company’s profit instead of being paid out to its shareholders as a dividend. The retained earnings of a company can be utilised to pay off debts or reinvested into the business.
A company’s retained earnings can be located in its balance sheet under shareholders equity and also determine its retention ratio.
Treasury stock refers to the shares that have been repurchased by a company from its investors. Companies mostly store their stocks in their treasury for future use, by way of selling it to raise capital at a later date or to prevent hostile takeovers.
When a company repurchases stocks, it reduces its shareholders equity and is consequently listed a negative number in the equity section of its balance sheet.
These four components utilised to calculate a company’s shareholders equity allow investors to gain a better insight into the company’s financial management.
A company’s shareholders equity can either be positive or negative. When the SE is positive, it means that the company has surplus assets that exceed its total liabilities. However, when the SE is negative, it means that its liabilities exceed its assets; and, if continued for a prolonged period, can even lead to insolvency of the balance sheet.
That is why individuals usually hesitate to invest in companies with negative SE, deeming them to be an unsafe or a risky investment option. Nonetheless, while SE is certainly one of the components that can aid investors to gauge a company’s financial health, it is not an absolute or definitive determinant for the same.
Shareholders equity, however, can be the most important metric in determining an equity investor’s return on investment. For example, SE is a crucial component that is used for return on equity calculation, which in turn allows one to measure the company’s efficacy in utilising the equity from its investors for profit generation.
Investors should, thus, consider shareholder’s equity alongside other relevant metrics to obtain a holistic idea about an organisation’s financial standing.