The Company stockholders’ equity also known as shareholders’ equity is an account contained in the balance sheet. It expresses the amount the owner or owners of a company has invested in the business over time.
In this article, you will get to understand the components of stockholder’s equity in the balance sheet, its calculation, and how it relates to the financial stability of the company.
What is a Balance Sheet?
Three fundamental financial statements make for a proper financial report, of which the balance sheet is one of them. In the balance sheet, you will be able to see the assets, liabilities, and shareholders’ (stockholders) equity of the company during the reporting period. It is also known as the statement of financial position or the statement of net worth.
The balance sheet of the company is divided into two main sides, the left and the right side. The left side displays the company’s assets while the right side displays the company’s liabilities as well as its shareholders’ equity. The accounting equation used to calculate the balance sheet is expressed as;
Assets = Liabilities + Shareholders equity
The balance sheet equation follows the foundational accounting principle of ‘double entry. Implying that the two sides of the equation must tally with each other, for every debit account, there must be a corresponding credit account.
The Balance sheet is essential to a company in various ways such as the following; it helps in giving a comprehensive list of the company’s earnings from all its sources.
It helps in determining the performance level of the company through calculations of several financial ratios. It also shows the liquid or solvent state of the company, including its efficiency level.
The balance sheet is made of three major components which are the asset, liability, and shareholders equity components. Based on our focus, we would be learning more about the last component, being the stockholder’s equity as it related to the balance sheet.
What is Stockholders Equity?
The stockholder’s equity is also known by other terminologies such as shareholders equity or share capital. Stockholders equity is seen as the owners’ residual claims on the company’s assets after all debts have been cleared.
In a more simple term, it is the remains of the company after all its liabilities have been separated from its assets. It represents the company’s net worth and the amount that will be given to shareholders of the company if all its assets are to be liquidated and all its debt settled.
The stockholders’ equity section consists of retained earnings, paid-in-capital, preferred stock, common stock, treasury stock, and par value (if bonds are issued). Information relating to authorized shares, par value, outstanding shares, and issued issues must need to be disclosed for each type of stock displayed.
Based on a company’s dividends preference and in times of liquidation, its preferred stock is listed first in the stockholders’ equity section. Stockholder equity can be either positive or negative.
It is said to be positive when the company’s assets exceed or cover its liabilities, while it is negative when its liabilities exceed its assets. If a negative state of the shareholders’ equity persists, the balance sheet is said to be in a state of insolvency.
A negative shareholders equity is considered an unsafe and risky investment by potential investors. Since it helps in analyzing the financial health of a company when combined with other financial accounting models.
It is instrumental in determining the company’s generated returns as opposed to the cumulative amount invested by its equity investors.
For instance, return on investment (ROE) helps in measuring the level of efficiency of a company’s management in utilizing the equity obtained from investors to make a profit. The ROE is calculated by dividing the company’s net income by its shareholders’ equity. That is;
Returns on equity ratio = company’s net income / stockholder’s equity
Aside from the ROE ratio, shareholders’ equity is also used to calculate ratios like the book value of equity per share (BVPS) and debt-to-equity ratio (D/E).
Book Value = Total common stock equity divided / the average number of common shares outstanding
Debt-to-equity ratio = total liabilities / total stockholder’s equity.
Component of Stockholders’ Equity
The following are the components that make up the stakeholders’ equity section in the balance sheet.
This captures any payment gotten from a company’s investors, either from preferred stock or common stock which exceeds the par value of the stock.
● Preferred stock:
This is a superior class of equity ownership that has higher claims on the assets and earnings of a company than common stock. Preferred stockholders receive shares of the company’s liquidation before the common stockholders but after all, debt has been settled.
● Common stock:
This is an ownership share in a company that permits its holders to receive dividends and gives them voting rights in shareholders’ meetings.
Should in case the company liquidates, common stockholders will be given shares of the company’s proceeds from the liquidation after its preferred stockholders and creditor have been paid.
● Treasury stocks:
These are shares in the company that is reacquired by the issuer. They are outstanding stocks retrieved by the issuing company.
But when reported in a financial statement, it is classified as issued stock rather than outstanding. The issuer can choose to resell the stock at a later period.
● Retained earnings:
These are percentages of the net earnings that were not distributed as dividends to shareholders within the expected time.
● Par value:
Par value for the stock is the stated stock price in a company’s charter. It is mostly used when there is no call price for preferred stock.
How To Calculate Stockholders Equity
The stockholder’s equity is calculated by subtracting the company’s total liabilities from its total assets. Information on the liabilities and assets is made available in the balance sheet. The accounting equation for the shareholder’s equity is expressed as
Stockholders’ equity = total assets – total liabilities
Ways to obtain the stockholder’s equity
If the balance sheet is not available, the following steps can be used to obtain the stockholders’ equity
- Determine the company’s total assets for the stipulated period from the balance sheet
- Cumulate the company’s total liabilities for the stipulated period still to be found in the balance.
- Determine the total stockholders’ equity by subtracting the total liabilities from the total asset.
Where the balance sheet is available, the shareholders’ equity can also be easily gotten from the bottom half of the balance sheet, since the necessary components of the shareholder’s equity have there-in been aggregated already.
If the above-mentioned routes are not visible, then there would be a need to collate the amounts from individual accounts in the company’s general ledger.
To get the shareholders’ equity, there would be a summation of the common stock, the preferred stock, the additional paid-in-capital, the retained earnings minus the treasury stock. Equation expressed as
Stockholders’ equity = common stock + preferred stock + additional paid-in-capital + retained earnings – treasury stock.
Stockholders’ equity can also be obtained by subtracting the treasury shares from the cumulation of the company’s share capital and its retained earnings. That is:
Stockholders’ equity = share capital + retained earnings – treasury shares
Determining a company’s stockholders’ equity is instrumental in determining the financial and fiscal health of the company. A positive stockholders’ equity speaks well of the company and boosts its chances of attracting investors. While the reverse is the case for a negative stockholders’ equity, as it would most likely ward off potential investors.
Although stockholder’s equity is essential in deciphering the financial state of a company, it should not be solely relied on but should be combined with other financial tools to get the truest financial state of the company.