Among the key pieces of information that investors need to have about businesses they own stock in, or are considering buying into, is how much the business is worth to its owners. Stockholders' equity is one measure of this type of value. It is not the same as net worth, but it indicates on a balance sheet how much equity stockholders' have, collectively, in the company.
Growth in Company Profit
When stockholders' equity rises, it may indicate growth in a company's profits. This is because the basic formula for determining stockholders' equity involves subtracting liabilities, or debts, from the company's assets.
As a business makes money by selling goods and services, it takes in cash. As long as this revenue exceeds expenses, the business makes a profit. By reducing costs or increasing revenue, the company increases its profits and drives up stockholders' equity at the same time.
Read More: What Is Considered a Good Gross Margin Percentage?
Sale of Stock
In some cases, a rise in stockholders' equity indicates that a company has sold additional shares of stock. Selling stock results in cash income, which increases the company's assets.
This is the opposite of what happens when a business borrows money to meet expenses. Borrowing creates a new liability and drives down stockholders' equity.
However, borrowing does not force the company to sell off ownership control, as selling stock does. Just as selling stock raises the value of shareholders' equity, it also creates new shareholders to share in that equity.
Greater Retained Earnings
Retained earnings are the earnings a business keeps either as cash, or to invest in itself, instead of issuing cash dividends to stockholders. From an investor's perspective, a company that chooses to hold onto its profits will see its stockholder equity go up.
That's because the retained earnings will increase the company's assets without any corresponding increase in liability. An increase in stockholders' equity on the balance sheet along with a decrease in the dividend rate points to greater retained earnings. A company's retained earnings include cash reserves and money spent to acquire new assets as well as money it uses to pay off debt, each of which directly increases stockholders' equity.
On the other hand, if a company pays out all of its profits as dividends, then stockholder equity will not change.
Change in Accounting Processes
Stockholders' equity depends on how a business values its assets in its financial statements. An increase in stockholders' equity may simply indicate a change in the method of valuing or depreciating assets, or an adjustment to previous accounting.
Stockholders' equity can also rise, or fall then recover value, during and following major financial events that impact accounting. For example, depending on its accounting practices, a company that acquires another business may show negative stockholders' equity for a short period of time during the process. Once the merger is complete, a consolidated balance sheet will show a rise in stockholders' equity.