Shareholders' equity, which is listed on the balance sheet, is used by investors to determine the financial health of a company. Shareholders' equity represents the amount that would be returned to shareholders if all the company's assets were liquidated and all its debts repaid. In short, shareholders' equity measures the company's net worth.
A company's shareholder equity is calculated by:
Total Assets - Total Liabilities = Shareholder Equity
A negative balance in shareholders' equity, also called stockholders' equity, means that liabilities exceed assets and can be caused by a few reasons.
What Does Negative Shareholder Equity On A Balance Sheet Mean?
Reasons for Negative Shareholders' Equity
Accumulated losses over several periods or years could result in a negative shareholders' equity. Within the shareholders' equity section of the balance sheet, retained earnings are the balance left over from profits, or net income, that is set aside to be used to pay dividends, reduce debt, or reinvest in the company.
In the event of a net loss, the loss is carried over into retained earnings as a negative number and is deducted from any balance in retained earnings from prior periods. As a result, a negative stockholders' equity could mean a company has incurred losses for multiple periods, so much so, that the existing retained earnings, and any funds received from issuing stock were exceeded.
Large dividend payments that either exhausted retained earnings or exceeded shareholders' equity would show a negative balance. Combined financial losses in subsequent periods following large dividend payments could also lead to a negative balance.
Borrowing money to cover accumulated losses instead of issuing more shares through equity funding could lead to negative shareholders' equity. Typically, the funds received from issuing stock would create a positive balance in shareholders' equity. As stated earlier, financial losses that were allowed to accumulate in shareholders' equity would show a negative balance, and any debt incurred would show as a liability. In other words, a company could cover those losses with borrowed funds, but shareholders' equity would still show a negative balance.
The amortization of intangible assets, such as patents or trademarks, is recorded in the shareholders' equity section and might exceed the existing balance of stockholders equity. The amortization of intangibles is the process of expensing the cost of an intangible asset over the projected life of the asset.
Negative shareholders' equity could be a warning sign that a company is in financial distress or it could mean that a company has spent its retained earnings and any funds from its stock issuance on reinvesting in the company by purchasing costly plant and equipment. In other words, negative shareholders' equity should tell an investor to dig deeper and explore the reasons for the negative balance.
For more on the balance sheet, please read "How Do the Income Statement and Balance Sheet Differ?"