Shareholders' equity, which is listed on a company's 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 a company's assets were liquidated and all its debts repaid. In this article, we'll review how shareholders' equity measures a company's net worth and some reasons behind negative shareholders' equity.
- Shareholders' equity, also called stockholders' equity, represents the equity the shareholders own in a publicly traded company.
- Companies calculate shareholders' equity by subtracting the total liabilities from the total assets.
- Negative shareholders' equity is a red flag for investors because it means a company's liabilities exceed its assets.
- Reasons for a company's negative shareholders' equity include accumulated losses over time, large dividend payments that have depleted retained earnings, and excessive debt incurred to cover accumulated losses.
- Shareholders' equity is significant to investors because it reveals the company's net worth, which is important to consider before investing in a stock.
How to Calculate Shareholders' Equity
A company's shareholders' equity is calculated by deducting total liabilities from total assets:
Total Assets - Total Liabilities = Shareholders' Equity
Shareholders' equity represents a company's net worth (also called book value) and measures the company's financial health. If total liabilities are greater than total assets, the company will have a negative shareholders' equity. A negative balance in shareholders' equity is a red flag that investors should investigate the company further before purchasing its stock.
What Does Negative Shareholder Equity On A Balance Sheet Mean?
Reasons for Negative Shareholders' Equity
A negative balance in shareholders' equity, also called stockholders' equity, means that liabilities exceed assets. Below we list some common 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
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.
A company's management that borrows money to cover accumulated losses instead of issuing more shares through equity funding could cause the company's balance sheet to show 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.
Amortization of Intangible Assets
The amortization of intangible assets, such as patents or trademarks, is recorded in the shareholders' equity section of the balance sheet 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.
The Bottom Line
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 property, plant, and equipment (PP&E). In other words, negative shareholders' equity should tell an investor to dig deeper and explore the reasons for the negative balance. A good place to start is for investors to learn how to read a company's income statement and balance sheet.