When a company talks about stockholders' equity, it means the total amount of paid-in capital that the company has received from investors in exchange for shares in the company granted by the issuance of stock. Found on the balance sheet and the statement of stockholders' equity, it represents all current assets in the company that investors own outright.
Almost all profit-making companies have increasing shareholder value as their objective, which basically means that the company is in business to increase shareholders' equity. In the end, this bolsters the company’s financial health.
There are multiple components of stockholders' equity, so it's a complicated exercise to determine what makes it go up or down. Multiple transactions can decrease stockholders' equity, including some favorable transactions that positively affect the company’s financial ratios. Changes in cash dividends and retained earnings both affect stockholders' equity.
Calculating Total Stockholders' Equity
Understanding stockholders’ equity begins with calculating stockholders’ equity. LibreTexts.org gives this basic equity formula for calculating total equity: Common stock plus retained earnings equals a company's total stockholders’ equity. You’ll find that preferred stock and common stock are listed separately on a company’s balance sheet if you’re looking up this information to make the calculations yourself.
Dividend payments and net losses can both subtract from this number. Retained earnings decrease when cash dividends and expense accounts are closed out. But there's a slight catch to the simplicity of this equation.
Dividend payments can change depending on how they're paid, as additional shares of stock, cash or a combination of the two. Cash dividends decrease equity but stock dividends don't. Cash dividends are effectively cash leaving the company so equity drops in proportion to the total paid out. Stocks remain invested in the company. Several other factors can decrease stockholders' equity as well, and can even result in negative stockholders’ equity in some situations.
A Reduction in Retained Earnings
The term “retained earnings” refers to the money a company has made that it hasn’t paid out as dividends on its share capital. It's the portion of equity representative of net income less losses and dividends. The company has elected to hold onto this money, at least for the short-term, to finance its operations and repay debt.
Retained earnings, including net income for the current year, make up part of stockholders' equity, according to Saylor Academy. Retained earnings reports the firm's cumulative net income from inception to the most recent accounting period. Stockholders' equity decreases when a corporation operates at a loss because the current year's net income reduces retained earnings.
Revenue, Expense, Asset and Liability Changes
Revenues increase stockholders' equity through retained earnings, and expenses decrease it because they subtract from cash flow. This helps illustrate the direct connection between a company's income statement and balance sheet. Stockholders' equity is equal to the sum of total assets plus total liabilities, so an increase in a company’s assets and contributed capital causes an increase in stockholders' equity, while a decrease in assets or increase in current liabilities causes a decrease in stockholders' equity.
Paying Out Stock Dividends
When corporations pay dividends on issued shares of stock, the payout activity decreases stockholders' equity if the payments are made in cash. The dividend payments reduce retained earnings, which in turn reduces stockholders' equity. Firms may also have a stockholders' equity account called treasury stock, which is a contra account to stockholders' equity. The contra account offsets the balance of stockholders' equity and reports stock repurchases.
A company may buy back its stock for several reasons. It may choose to distribute it to employees using a stock option plan, distribute it as a stock dividend or repurchase it to defend against a hostile takeover bid.
Other Important Adjustments
Stockholders' equity may include other items such as other comprehensive income, or OCI. Items recorded in this account do not impact the income statement or some other financial statements. They arrive at stockholders' equity through retained earnings, which means that an accountant records them directly to the OCI account in stockholders' equity.
These entries include gain or loss on available-for-sale securities and outstanding shares, or foreign currency translation adjustment. They can either increase or decrease stockholders' equity.
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