Shareholder's Equity - Explained
What is Shareholder's Equity?
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Table of ContentsWhat is Equity on the Balance Sheet? Types of EquityCalculating Shareholder's EquityWhat Does Shareholder Equity Tell You?Example of Calculating Shareholder's Equity
What is Equity on the Balance Sheet?
Equity, also known as Shareholder's Equity, is a special type of category of accounts representing the owner's interest in the business or the owner's claim on the assets.
Generally, this consists of what the owners put in or what they have at stake in the business. It might include contributed capital or other value and retained earnings to which the owners are entitled.
In the accounting equation, Assets = Liability + Equity.
Restated, Equity = Assets - Liabilities.
So, equity equals what you have minus what you owe. This is often referred to as net assets, residual equity, or stockholder's equity.
Types of Equity
Equity comes really into two major categories:
- Contributed Capital - This is the value you contributed to the company. It may be cash, land, equipment, etc. Investors generally receive an ownership interest in exchange for their contributed capital.
- Retained Earnings - Retained earnings are made up of Revenue - Expenses - Dividends or Distributions to Owners
Calculating Shareholder's Equity
When using the accounting equation such as the formula above for the calculation of shareholders equity, there are some guidelines that serve as the basis for the calculation.
First, the total assets of a company recorded on its balance sheet must be identified.
Second, the liabilities or debts that a company owes must also be separated.
Once both have been identified, the equity or assets of the company must be totaled and its sum deducted from the total liabilities of the company for the shareholders equity to be known.
The retained earnings of a company is an important factor to be considered when calculating shareholders' equity. This is a form of savings that a company makes from its net earnings. These profits are put aside and not paid to shareholders
What Does Shareholder Equity Tell You?
A company can either have surplus of assets after paying its debts or have a shortage of assets in paying its liabilities. If the assets available to a company are sufficient to pay its debts, the company has a positive shareholders equity. Shareholders equity would be negative if the available assets cannot pay the debts of a company, and this can have a negative impact on the company. Shareholders equity does not single handedly depict a company's financial health, there are other factors to be considered.
However, shareholders equity can give a snapshot to the financial health of a company, in many cases, investors avoid companies with negative shareholders equity. Investors can also what the assets and liabilities of a company look like through its shareholders equity.
The total assets of a company which comprises of current and non-current assets as well as the liabilities of a company which include current liabilities and long-term liabilities are determined.
The liabilities or the debts of a company are deducted from the assets and the remaining value make up the shareholders equity.
Generally, investors look out for companies with positive shareholders equity. Market analysts also measure the retained earnings of a company alongside its shareholders equity in determining the financial stability of a company. Shareholders equity also determines the level of return a company generates after it has settled its debts.
Here are some points you should note about shareholders equity;
- Shareholders equity refers to the residual claims shareholders of a company can make after all liabilities have been settled.
- Shareholders equity is realized when the total liabilities of a company are deducted from its assets.
- Shareholders equity plays an important role when evaluating the financial health of a company but it cannot be used as a definitive indication of the company's health.
- The amount invested by investors and the returns a company make can be measured through shareholders equity.
Example of Calculating Shareholder's Equity
Here is an example of shareholders equity; If Company XYZ has a total assets worth $15.5 million in 2018 and the liabilities accrued for that same fiscal year is $9.4 million. The shareholders equity will be calculated by deducting the company's liabilities from its assets for that fiscal year. Hence, Shareholders' equity = $15.5 - $9.4 = $6.1 million. This illustration simply depicts how shareholders equity is calculated. There is a distinction between equity and shareholders equity. Equity refers to the value of a company that can be attributed to the owners of the company. Shareholders equity refers to the residual claims of corporation owners of a company after its debts have been paid. That is, the amount left for the shareholders of a company after all liabilities have been deducted from a company's assets.