What are Equities?
In the stock market, Equities are the shares in a company’s ownership. It generally refers to the amount shareholders (the investors who own the share of the particular company) will receive if all the debts of the company are paid off and its assets have been liquidated. In the case of acquisitions, equity can be referred to as the value of the company’s sales, deducting the liabilities, if any, that are owed by the company which are not transferred with the sale. The shareholders are partial owners of the company.
A shareholders’ equity is calculated as follows:
Shareholders’ Equity = Total Assets – Total Liabilities
What are positive equities?
If the value of the total assets is more than total liabilities, then equities are positive. It can also be said that when an asset bought is financed by a loan, and if the value of that asset grows over time or the amount of the debt (loan) decreases over time, it is classified as positive equity.
Can there be negative equities?
Now the question arises, how can equities be negative? The answer to that is yes. If the liabilities supersede the assets, we have a situation of negative equities. In other words, if the current value of the asset bought, which is financed by debt such as loans or mortgages, falls below the debt amount owed, then there prevails a situation of negative equities. This usually happens when the value of the asset depreciates over time.
For a company, if the accumulated losses are enormous or the dividends paid to the shareholders are large, the company may have negative equities.
Types of negative equities
Negative equities can be of a few types.
Negative Equities for Assets
These are most common in the automobile or housing sectors as people usually finance the purchase of a house or car through loans or mortgages. When the value of the car depreciates and falls below the debt value, or the house’s value fluctuates with the variations in real estate prices such that the current value falls below the bank loan or mortgage value, the resulting situation is negative equities.
Negative Shareholder Equities
Negative shareholders’ equities refer to the situation when a company’s liabilities exceed the company’s assets. This usually happens when a company’s accumulated losses are greater than the consolidated payments made to the shareholders and the total earnings from previous payments. The negative equities can also arise from large dividend payments and also from large borrowings made to cover losses of the company.
Negative Net Worth
When an individual faces negative equities, it is termed as negative net worth. This occurs when the individual’s liabilities exceed the assets they own.
In the share market, negative equities mainly refer to the shareholders’ equities.
Reasons Behind Negative Shareholder Equities
In the balance sheet of a company, the shareholders’ equity section contains the retained earnings of the company, which can be described as the net income, or the balance left over after the deductions of profits. This amount is used to pay the dividends, reinvest it in the company itself, pay off any debts, or even reduce the debt amount. When there is a net loss instead of profits, the loss is deducted from the retained earnings, including any balance in the retained earnings from previous periods. When a company suffers huge losses or losses in multiple periods, the amount of losses may exceed the amount of these retained earnings and the funds from issuing stocks, resulting in negative equities.
Huge Dividend Payments
If the dividend payment is large enough to exhaust the retained earnings or exceeds the shareholders’ equities, the result is negative equities. Also, accumulated losses over multiple periods along with large dividend payments are causes of negative equities.
Borrowing of Funds
The losses incurred by a company can be funded by borrowing money or issuing more equity shares. Raising funds through the issuance of shares results in positive shareholders’ equity in the balance sheet. When the management opts to borrow money rather than equity funding, the shareholder’s equity section in the balance sheet becomes negative. We already know that financial losses incurred by the company reflect negative equity in the company’s balance sheet, and hence, any debt would be under the company’s liabilities. So, even though borrowed funds cover the losses, the shareholders’ equities would still show a negative balance.
Amortisation of Assets that are Intangible
Assets such as patents or trademarks are called intangible assets. Amortisation of such assets, that is paying off the cost of the intangible asset over the projected lifetime of the asset, also falls under the shareholders’ equity section of the company’s balance sheet. If the amortisation amount exceeds the existing balance in the shareholders’ equity, a situation of negative equity prevails.
Repurchase of Treasury Stocks
A company might buy its common stocks according to its stock repurchase plan but doing so reduces the amount of equity. If a company repurchases large amounts of common stock, it may lead to negative equity.
Creation of Future Provisions
When companies expect financial liabilities in the future, they sometimes create huge provisions for them. This can lead to negative equities.
Consequences of Negative Shareholder Equities
Negative equities of a company lead to a fall in their credit ratings and hence are subjected to higher interest rates and lesser credit periods, and sometimes even denial of credit sales, from lending institutions. The companies face a decrease in their corporate valuations as well as in orders, as clients are weary of the company upholding the contracts. Funding through borrowing or even equity funding becomes difficult due to the decrease in credit ratings of the company.
The stock prices also fall if the company faces a large amount of negative equities, it may lead to the company being unable to pay dividends to the shareholders. In some cases, as per law, the company can be classified as a sick company. In dire situations, the company may resort to employee lay off, which lowers employee morale and also degrades the company’s name and credibility.
The value of equities is an indicator of a company’s financial health, and negative equities can mean that a company in financial health is in distress. Hence, an investor should research the cause of the negative equity of a company and plan their investments accordingly.