Stockholder or shareholder equity exists in two forms: positive and negative. Shareholders' equity is positive if a company’s assets are equal to or greater than its liabilities. In contrast, shareholders' equity is negative if a company’s liabilities exceed its assets.
A company becomes insolvent when its shareholders' equity becomes a negative number and remains so for an extended time. Thus, the stockholders' equity is greater than its liquidation value.
Investors perceive a company with negative shareholders' equity to be a risky venture. Shareholders' equity for a period, however, is but one indicator of a company’s financial standing. Another is its average shareholders' equity.
Read more: Can Shareholder Equity Be Negative?
Retained Earnings and Shareholders Equity
Retained earnings are one element of shareholders' equity. Its dollar value equals the portion of a company’s net earnings that has not been distributed as dividends to shareholders. When need be, a company relies on its retained earnings to pay expenses and fund the company’s future growth.
Elements of Shareholders Equity
Total assets, current assets and non-current assets are values that are needed to calculate a company’s shareholders' equity, the result of which is published in a company’s balance sheet. Whereas total assets equal the total of a company's current assets and non-current assets, its total liabilities equal current liabilities plus non-current liabilities. Once total assets and liabilities are determined, shareholders' equity can be calculated.
Current and Long-Term Assets
Current assets consist of cash and other company assets that may be converted to cash within 12 months' time (or less). These assets include inventory and accounts receivable. In contrast, long-term assets are those that require more than a year to convert to cash.
Current and Long-Term Liabilities
Total liabilities are the sum of current and long-term liabilities. Current liabilities are debts that a company must repay in less than a year, such as accounts payable and taxes payable. In turn, long-term liabilities are those debts for which the term is more than one year, such as bonds and leases.
Read more: Significance of Negative Return on Shareholder's Equity
Shareholders Equity Calculation
Shareholders' equity is calculated by subtracting total liabilities from total assets. This equation is also referred to as the accounting equation or the balance sheet equation.
For example, assume that the total assets of XYZ company equal $3.2 million and its total liabilities equate to $1.1 million. In this case, XYZ shareholders' or stockholders' equity equals $2.1 million.
The steps required to calculate shareholders' equity, which is the company's net worth, include the following:
- Review a company’s balance sheet to identify its total assets.
- Scan the "Liabilities and Equity" section of the balance sheet to locate the company’s total liabilities.
- Subtract the total liabilities from the total assets to obtain shareholders' equity.
Average Shareholders Equity
Scan the "Liabilities and Equity" section of a company's balance sheet to determine the shareholders' equity amount for one period. Repeat the process for each period you want to include in the average shareholders' equity calculation.
Once you've determined the shareholders' equity for each of the company's reporting periods that are of interest to you, add the numbers together to obtain the total shareholders' equity for all periods under consideration. Next, divide that total by the number of periods you are considering. The result is the company's average shareholders' equity for all periods selected.
Benefits of Determining Average Shareholders Equity
Investors turn to the average shareholders' equity (ASE) for a variety of reasons. For instance, it's a means to determine the reliability of a company’s returns over time and the likelihood those returns can be sustained in the future.
The figure also provides the investor a means to focus on a figure that directly relates to her investment, shareholders' equity, rather than other figures, such as share buybacks, dividends or capital concerns, which are events that contribute to ASE, but that don’t occur on a consistent basis.
