What is the 'Shareholder Equity Ratio'
The shareholder equity ratio determines how much shareholders would receive in the event of a company-wide liquidation. The ratio, expressed as a percentage, is calculated by dividing total shareholders' equity by total assets of the firm, and it represents the amount of assets on which shareholders have a residual claim. The figures used to calculate the ratio are taken from the company balance sheet.
BREAKING DOWN 'Shareholder Equity Ratio'
The balance sheet is based on a formula: assets less liabilities equals equity. If, for example, a company sold all of its assets for cash and used the cash to pay off all liabilities, any remaining cash equals the firm's equity. A company's shareholders' equity is the sum of common stock, additional paid in capital and retained earnings, and the balance is considered to be the true value of a business.
The Differences Between Additional Paid in Capital and Retained Earnings
Shareholders' equity can increase when a firm issues more common stock, because that affects both the common stock and the additional paid in capital accounts. Assume, for example, that XYZ firm issues 1,000 shares of $10 par value common stock for $30 a share. Common stock is increased based on the par value of each share, or $10,000, and additional paid in capital is increased by the remaining $20 per share ($20,000).
When a company generates net income, those profits increase the retained earnings in the shareholders' equity section of the balance sheet. At the end of each month, the net income in the income statement is adjusted to zero, and the total is posted to retained earnings. The retained earnings balance is the sum of all net income since inception less all cash dividends paid since the firm started.
How a Company Liquidation Takes Place
When a business chooses to liquidate, all of the company assets are sold, and the creditors and the shareholders have claims on assets. Secured creditors have the first priority, based on the specific assets that serve as collateral for a debt. Other creditors, such as bondholders, are next in line to claim assets, followed by the shareholders. Preferred shareholders have priority over common shareholders when a company chooses to liquidate. A larger asset balance means that shareholders are more likely to receive some assets during the liquidation. However, there are many cases in which shareholders don’t receive any value, such as a bankruptcy situation when a company is forced into liquidation.