Are you aware that shareholders are the actual owners of a company? They contribute to the capital by buying the shares of the company. Most companies raise funds by issuing shares to the public. When individuals purchase these shares, they become owners, i.e., the equity shareholders of the company. Notably, the shareholder’s equity is one of the financial attributes that reflects the company’s financial health.
Want to know more about shareholder’s equity? Let’s get started!
What is Shareholder’s Equity?
Shareholder’s equity is the actual value of the business, representing the amount invested by the owners of the company. We also know it as equity, owner’s equity, or stockholder’s equity. The equity amount includes share capital, retained earnings, and other assets entitled to the company’s owners.
In the accounting sphere, shareholder’s equity implies the total company’s assets minus total liabilities, i.e., reflecting a company’s net worth after paying all of its debts. Sometimes, it is also referred to as book value equity. That means, if a company gets liquidated and paid all its debts, the entitled ownership of the remaining equity is with the shareholders of the company.
Essential Components of Shareholder’s Equity
In the balance sheet, shareholder’s equity includes various components that help investors to know the vital financial aspects and equity sources. These items are present in the balance sheet, providing an alternative approach to computing the owner’s equity. Let’s check out the major components of Shareholder’s Equity:
Outstanding Share Capital
It is the capital raised for the company by issuing the shares to the public. Outstanding share capital constitutes both equity and preference shares. While assessing these shares, we need to consider the book value of the stocks, not the market price. This is because market prices are volatile in nature.
Suppose a company issues 2 lakh shares in the market at ₹10 per share, then the outstanding share capital would be ₹20 lakhs.
Additional Paid-in Capital
Additional Paid-in Capital denotes the difference of value for the shares subscribed above par level, i.e., at a premium. It is calculated by subtracting the book value of the common or preferred shares from the cost at which they are sold.
For example, if a company issues 1 lakh shares at ₹12 per share, and the book value of each share is ₹10. This means the additional paid-in capital would be ₹2 lakhs.
Retained Earnings
It is the part of profits that the company reinvests for the expansion and development of the business. After earning profits in the financial year, the company chooses to retain a portion as retained earnings, and the rest is distributed among the shareholders as dividends.
Here is an example. Suppose, if a company earns a profit of ₹40 lakhs in a financial year and distributes ₹ 30 lakhs among the shareholders as dividends. The company keeps the remaining ₹10 lakhs as retained earnings. While calculating shareholder’s equity, this amount is added to the share capital and makes up a part of the shareholders’ fund.
Treasury Stock
Sometimes companies repurchase previously issued stocks from their shareholders. These reacquired shares are known as treasury stocks. In the balance sheet, we deduct treasury stock from shareholder’s equity and record it as a negative amount under the equity section.
The primary purpose of holding treasury stock is to secure the company’s future, such as raising capital to tackle any uncertainties.
Calculation of Shareholder’s Equity
There are two major ways to calculate shareholder’s equity. Let’s understand:
Shareholder’s Equity Formula 1
Shareholders’ Equity = Total assets – Total liabilities
It is the simplest and basic accounting equation to calculate owner’s equity – the difference between total assets and total liabilities.
Total assets – It comprises all the long-term and current assets present in the balance sheet, including investments, land & building, equipment, cash equivalents, accounts receivable, and more.
Total Liabilities- It includes all current and long-term liabilities such as debts, accounts payables, taxes, and others.
Shareholder’s Equity Formula 2
Shareholders’ Equity = Share capital + retained earnings – treasury stock
This equation is also known as the investor’s formula. Here, we use major components of shareholder’s equity to find the real value. Investors mainly use this formula to assess the company’s financial viability.
As per the formula, we add outstanding share capital and retained earnings, whereas the share buybacks are reduced to get shareholder’s equity.
Now we will calculate shareholder’s equity using above -mentioned formulas. Here’s a balance sheet of ABC company:
As per balance sheet ABC, the calculation of shareholder’s equity is as follows:
Using Formula 1
Shareholders’ Equity = Total assets – Total liabilities = (₹ 8,80,000 – ₹ 1,80,000) = ₹ 7,00,000
Using Formula 2
Shareholders’ Equity = Share capital + retained earnings – treasury stock
= ₹ 6,00,000 + ₹ 1,00,000 – 0
= ₹ 7,00,000
Relevance of Shareholder’s Equity
Shareholder’s equity is a vital indicator of the company’s investment and its financial strength. It can be positive or negative, reflecting the various aspects of the company. The shareholder’s equity will be positive if total assets exceed the total liabilities. It denotes the company’s financial sustainability and has required surplus assets to pay back to its shareholders.
At the same time, if total liabilities are more than total assets, then shareholder’s equity will be negative. It hints that the company’s financial health is unpleasant; the business is not performing well and has no reserves to safeguard shareholders. If the situation continues for an extended period, the company stands at the risk of bankruptcy. Such an event can be a caution light for the intended investors.
Well, shareholder’s equity is one aspect of weighing a company’s financial health. It is not the definite or only one. For example, negative equity can be seen in startup companies, especially in the early phase of their journey. However, investors look for stability and good returns; that’s why they majorly invest in companies with positive owner’s equity.
The Bottom Line
Shareholder’s equity is a significant financial metric for analyzing a company’s financial outlook. It gives rightful direction to investors about the improvement option. They assess the company’s balance sheet to know the fundamentals so that they can invest in sustainable business.
Shareholder’s equity also helps in determining the ROE (Return on Equity) ratios, indicating how effectively a company generates returns with its share capital. So, it is an indispensable factor present in the balance sheet that gives a comprehensive idea of a company’s financial well-being.
Leave a Reply