Investors and corporate accounting professionals look to shareholders'equity (SE) to determine how a company is using and managing its initial investments and to determine the company's valuation.
The number for shareholders' equityis calculated simply as total company assets minus total company liabilities. But several components make up this equity calculation.
Key Takeaways
- Shareholders' equity is the amount of money that a company could return to shareholders if all its assets were converted to cash and all its debts were paid off.
- Four components that are included in the shareholders' equity calculation are outstanding shares, additional paid-in capital, retained earnings, and treasury stock.
- If shareholders' equity is positive, a company has enough assets to pay its liabilities; if it's negative, a company's liabilities exceed its assets.
- A look at shareholders' equity helps investors assess the worth of a company and its long-term sustainability.
About Liquidation
Shareholders' equity, as noted, is the total amount that a company could repay shareholders in the event of liquidation. In the real world, this is unlikely to happen. Common stock shareholders are last in line for repayment in the event a public company files for bankruptcy.
Outstanding Shares
The number of outstanding shares is an integral part of shareholders' equity. This is the amount of company stock that has been sold to investors and not repurchased by the company. It represents the total amount of stock the company has issued to public investors, company officers, and company insiders, including restricted shares.
This figure includes the par value of common stock as well as the par value of any preferred shares the company has sold.
Outstanding shares are also an important component of other calculations, such as those for market capitalization and earnings per share (EPS).
Additional Paid-in Capital
The number for shareholders' equity also includes the amount of money paid for shares of stock above their stated par value, known as additional paid-in capital (APIC). This figure is derived from the difference between the par value of common and preferred stock and the price each has sold for, as well as shares that were newly sold.
APIC only occurs when an investor buys shares directly from a company. It represents the additional amount an investor pays for a company's shares over the face value of the shares during a company's initial public offering (IPO).
You can find the APIC figure in the equity section of a company's balance sheet.
Retained Earnings
When a company retains income instead of paying it out in dividends to stockholders, a positive balance in the company’s retained earnings account is created. A company generally uses retained earnings to pay off debt or reinvest in the business.
This figure is typically the largest line item in the shareholders' equity calculation. You can find a company's retained earnings on its balance sheet under shareholders' equity or in a separate statement of retained earnings.
A company may refer to its retained earnings as its "retention ratio" or its "retained surplus."
Treasury Stock
The final item included in shareholders' equity is treasury stock, which is the number of shares that have been repurchased from investors by the company. A company will hold its own stock in its treasury for later use. It might sell the stock at a later date to raise capital or it might use it to prevent a hostile takeover.
Treasury stock reduces total shareholders' equity on a company's balance sheet. This figure is subtracted from a company's total equity, as it represents a smaller number of shares that are available to investors.
A company lists its treasury stock as a negative number in the equity section of its balance sheet. Treasury stock can also be referred to as "treasury shares" or "reacquired stock."
Why Is Shareholders' Equity Important?
A company's shareholders' equity tells the investor how effectively a company is using the money it raises from its investors in order to generate a profit. Since debts are subtracted from the number, it also implies whether or not the company has taken on so much debt that it cannot reasonable make a profit.
What Is a Good Shareholders' Equity Number?
Some investors judge a company's shareholders' equity by first determining its shareholder equity ratio. This ratio is calculated by dividing shareholders' equity by total company assets.
The result indicates how much of the company's assets were funded by issuing stock rather than borrowing money.
The closer the ratio is to 100%, the more its assets have been financed with stock rather than debt. In general, a number below 50% indicates a company that is heavily leveraged.
What Does a Shareholders' Equity Ratio of 100% Indicate?
A shareholders' equity ratio of 100% means that the company has financed all or almost all of its assets with equity capital raised by issuing stock rather than borrowing money.
The Bottom Line
Ultimately, shareholders' equity is used to evaluate the overall worth of a company. But numerous components of the balance sheet calculation are needed to gain deeper insight into a company's financial management. By calculating shareholders' equity, an investor can determine if a company has enough assets to cover its liabilities, which is an important factor in deciding whether a company is a risky or safe investment.
However, shareholders' equity is just one of many metrics an investor might consider when evaluating a company's financial health. You can also measure a company's financial health by reviewing its liquidity, solvency, profitability, and operating efficiency.
