Issuing shares is a popular way for companies to raise funds. When an investor purchases such shares, they become shareholders of the company. Shareholders contribute to the company’s share capital, and in return, they get to own a stake in the company equivalent to their shareholding. The share capital becomes a permanent source of funding for the company, and is paid back to the equity shareholders only at the time of the company’s liquidation.
A look at the shareholder equity reveals much about the company’s financial worth. Let’s deep-dive.
What is shareholder equity?
Shareholder equity is the net worth of the business – an indicator of the amount of investment that investors have made in the company. A quick view of the balance sheet of the company shows three categories under shareholder equity: Common shares, Preferred shares and Retained earnings.
From another perspective, shareholders’ equity can be denoted as the amount the company has left to pay back its shareholders after it has paid its debts and liabilities. Mathematically, this is the company’s total assets minus the total liabilities.
What makes up the shareholders’ equity?
The main components of the shareholders’ equity or shareholders fund include the following:
The share capital
This consists of:
The outstanding share capital
This is the total amount of capital raised by the company by issuing shares to the public. If the company issues 1 lakh shares to the public at Rs 10 each, the outstanding share capital in this case would be: 1 lakh x Rs 10 = Rs 10 lakh.
Remember to consider the share’s book value or par value, and not the market value that fluctuates by the minute. Outstanding share capital can be assessed for equity shares as well as preference shares.
Additional paid-in capital
This is the difference between the book value of the share issued and the cost at which the shares were subscribed. For example, suppose a company issues 1 lakh shares at Rs 120, but the book value is Rs 100. Here, each share is being issued at a premium of Rs 20. Therefore, the additional paid-in capital would be Rs 20 x 1 lakh = Rs 20 lakh.
Retained earnings is the portion of the profit that the company chooses to reinvest in the company for growth and expansion. The remainder is distributed among shareholders as dividends. For example, if a company earns a profit of Rs 1 crore in a year and distributes Rs 30 lakh in dividends, the rest Rs 70 lakh is called the retained earnings.
Retained earnings are added to the share capital in the calculation of shareholders’ equity because they form a part of the shareholders fund.
Companies often buy back some of their outstanding shares from their shareholders. The shares bought back are called treasury stock. They reduce the shareholders’ equity and are, thus, subtracted from the value of the share capital when calculating shareholders’ equity.
Calculation of shareholders’ equity
There are two ways to calculate the shareholders’ equity.
Shareholders’ Equity = Total assets – Total liabilities
In this formula, all the liabilities, current and long term, are summed and this is deducted from the total of all the assets of the company. The excess of assets over liabilities is the shareholders’ equity.
Shareholders’ Equity = Share capital + retained earnings – treasury stock
Here, the outstanding share capital of the company is added to the retained earnings, and is deducted for any share buybacks to arrive at the shareholders’ equity.
Here’s a sample balance sheet of a company:
|Liabilities||Amount (Rs)||Assets||Amount (Rs)|
|Share capital||50,00,000||Land and building||35,00,000|
|Retained earnings||10,00,000||Plant and machinery||25,00,000|
|Long term debt||20,00,000||Stock||15,00,000|
Calculation of shareholders’ equity
- Using formula 1
Total Assets – Total Liabilities
= Rs 86,50,000 – Rs 26,50,000
= Rs 60,00,000
- Using formula 2
Share capital + retained earnings – treasury stock
= Rs 50,00,000 + Rs 10,00 000 – 0
= Rs 60,00,000
You may use either formulae, your result would be the same!
Why should investors know about shareholders’ equity?
Shareholder’s equity essentially acts as an indicator of the financial well-being of the company. In cases where the assets of the company exceed its liabilities, the shareholders’ equity would be positive. This means that the company has excess assets that can be used to pay back the shareholders should things go downhill. However, should the shareholders’ equity be negative, this is a warning for prospective and existing investors. It means that the company’s debt to equity ratio is skewed in an unconducive manner, a scenario that is not favourable. Should the shareholders’ equity continue to remain negative for consecutive years, the company faces a danger of liquidation.
When a prospective investor scouts the market for making investments, a look at the shareholders’ equity could be a ready reckoner to give an idea of whether the company is on good footing or not. Shareholders’ equity, thus, can help investors make the right investment decisions. Shareholders’ equity also plays an important role in the computation of the return on equity – an assessment of how effective the company is in using its share capital to generate returns.
Thus, the shareholders’ equity is a marquee factor within a company’s balance sheet that gives investors a quick peep into the underlying financial strength of the company.