Shareholder equity is a key way of measuring how much a company is worth. It's simply the difference between assets and liabilities. If liabilities are higher than assets, the shareholder equity is negative. There are a number of reasons why this can happen. Although negative equity is a red flag for problems, it's not inherently a sign of financial doom.
Shareholder equity, also known as owners' equity, is the amount left over when a company's liabilities are deducted from its assets. In essence, it's how much the company is worth, and thus the overall value of what the shareholders own. As well as being reduced when a company takes losses, shareholder equity falls when shareholders receive dividends.
Paid-in Capital and Retained Earnings
Shareholder equity also equals the total of paid-in capital and retained earnings. Paid-in capital is the total amount that shareholders have put into the company, either by putting up cash to start the business or by buying stocks when they were first issued. Paid-in capital is inherently a positive amount.
Retained earnings is the total amount of profits a company has made in its history, minus the amount it has paid out in dividends. This isn't the same as its cash on hand, as some of the retained earnings have been used for buying assets.
Causes of Negative Shareholder Equity
There are three fundamental causes of negative shareholder equity, though, often, two or even three of the causes will have played some role. The first is simply that in the long run, the company has made losses — this is particularly likely in the early years of the company. The second is that the company has run up a large amount in liabilities, such as by borrowing heavily. The final reason is that the company has paid out more in dividends than it has made in profits.
Negative shareholder equity doesn't necessarily mean a company is in any financial difficulty. Negative shareholder equity is only a problem if it leads to cash-flow issues. It's possible, for example, that a company may have a large negative shareholder equity because it owes a lot of money on loans, but it may not be a problem because the company is making high profits and can confidently expect to pay back all of the loans on schedule. When examining such a company, it's important to distinguish between short-term and long-term assets and liabilities.
A professional writer since 1998 with a Bachelor of Arts in journalism, John Lister ran the press department for the Plain English Campaign until 2005. He then worked as a freelance writer with credits including national newspapers, magazines and online work. He specializes in technology and communications.