Stockholders’ equity shows the quality of a firm’s economic stability; it also provides insights into its capital structure. Finding it on the balance sheet is one way you can learn about the financial health of a firm. Alternate names: shareholders’ equity, book value, owners’ equity, net worth For example, stockholders’ equity represents the amount of assets remaining after subtracting total liabilities from total assets on a company’s balance sheet. So, if a company had $2 million in assets and $1.2 million in liabilities, its stockholders’ equity would equal $800,000.
How Does Stockholders’ Equity Work?
Stockholders’ equity usually comes from three sources:
Capital stock: This is cash or other assets paid in by investors when the company was raising capital; it is in exchange for issuing shares of common stock or preferred stock. Paid-in surplus: Also known as “paid-in capital,” this is capital given by investors in exchange for stock. It doesn’t include stock from money generated from earnings or donations. Retained earnings: These are accumulated profits that a business has kept for reinvestment in the firm. It is not paid out to shareholders as dividends or used in the repurchase of stock.
A firm’s balance sheet will often feature two columns: a left column listing its assets, and a right column showing its liabilities and owners’ equity. Some balance sheets will list assets at the top, then liabilities. Finally, stockholders’ equity is shown at the bottom. Total assets should equal the total liabilities plus owners’ equity. Shareholders’ equity on a balance sheet is adjusted for a number of items. For instance, the balance sheet has a section called “Other Comprehensive Income,” which refers to revenues, expenses, gains, and losses, which aren’t included in net income. This section includes items like translation allowances on foreign currency and unrealized gains on securities. Stockholders’ equity increases when a firm generates or retains earnings, which helps balance debt and absorb surprise losses. For most firms, higher owners’ equity means a larger cushion, which provides more flexibility to recover in the event that the firm experiences losses or must take on debt due to poor underwriting or an economic recession, for example. Lower stockholders’ equity is sometimes a sign that a firm needs to reduce its liabilities. For some businesses, especially those that are new or conservative and have low expenses, lower stockholders’ equity is not a problem. That’s because it doesn’t take much money to produce each dollar of surplus-free cash flow. In those cases, the firm can scale and create wealth for owners much more easily, even if they are starting from a point of lower stockholders’ equity.
Alternatives to Stockholders’ Equity
When making investment decisions, stockholders’ equity is not the only thing you should look at. A single data point in a company’s financial statement cannot tell you whether it is a good risk or not. To make more informed investing decisions, look at stockholders’ equity on a balance sheet as well as:
Annual reports: These are yearly statements on a company’s financial situation; they may also include details on goals, management, leadership, and culture. Form 10-K: This filing is required by the Securities and Exchange Commission (SEC). It provides an overview of a company’s financial condition; it’s sometimes sent to shareholders in place of an annual report. Debt-to-equity ratio: This figure compares assets to liabilities. It can help you identify a company that carries too much debt. Price-to-earnings ratio: This ratio compares the price of shares to the per-share earnings of the company. Higher ratios indicate more potential for growth. Industry stability and growth: This information provides context on the company’s potential opportunities for profitable growth. Dividends: These payments can indicate stability and growth unless they make up too high a percentage of profit. Income statement: This information allows you to compare earnings, expenses, and net profit over time.
When examined along with these other benchmarks, the stockholders’ equity can help you formulate a complete picture of the company and make a wise investment decision.
