A balance sheet provides hints of future events that may either threaten a company's well-being or thrust it into the upper echelon of its industry. While a balance sheet is less dramatic than a soothsayer's warning, investors look to a particular line item in it, namely shareholder equity, to get an idea as to a company's financial health or its net worth.
For instance, a shareholder deficit, or equity deficit, may foretell company losses that are so significant that they offset the cash that investors paid for the company's stock and the earnings the company retained from prior period operations. On the other hand, a negative shareholder equity may foreshadow extraordinary growth due to a commitment of the majority of a company’s cash to opportunities that leaders believe will yield profits.
Read More: What Is Included in a Common Stockholder's Equity?
What Is Shareholder Equity?
Shareholder equity equals total assets minus total liabilities. Shareholder equity is equivalent to a company's net worth or book value, which equates to its financial well-being.
As long as a company's assets exceed its liabilities, the company will maintain a positive shareholder equity. Once an equity deficit exists, however, potential investors may see nothing but this red flag and consider the risk associated with investing in the company to be far greater than the likely reward of doing so.
Shareholder Equity, Retained Earnings and a Shareholder Deficit
Shareholder equity is the owner's claim on a company's assets after subtracting total liabilities from total assets. Retained earnings is the portion of a company's profit that is held back from its net income at the end of a financial reporting period less the dividends it pays shareholders. A company saves or retains earnings for future use as an element of shareholder’s equity.
Because shareholder equity represents the residual claim of a company's owners on its assets after company debts are paid, and retained earnings, equity increases as retained earnings increase and as profits are earned during an accounting period. In turn, retained earnings decrease when a company suffers a loss or pays dividends. When a company's losses are so significant that they offset the cash investors paid for the company's stock and the earnings the company retained from prior period operations, an equity deficit exists.
Read More: Can Shareholder Equity Be Negative?
What Is a Net Equity Deficit?
A company's shareholder equity may be a positive or negative figure. If shareholder equity is a positive number, the company's assets are sufficient to pay its liabilities when they become due. When shareholder equity is a negative number, the company's liabilities exceed its assets. Eventually, if an equity deficit persists for an extended time, an equity deficit exists, and the company is considered to be insolvent.
Events That May Lead to an Equity Deficit
An equity deficit may result if one company acquires another only to amortize the acquired company's assets. Also, an equity deficit may result when a company suffers a massive loss during one period and then another to which the company's management responds by debt rather than issuing additional shares.
Alternatively, an equity deficit may result if a company accrues large liabilities in anticipation of their occurrence. What's more, an equity deficit may result is a company's board issues dividends equal to a substantial portion of the company's stockholder equity.
End Result of an Equity Deficit
When a company's total expenses, including its taxes, fees, interest on its debt and depreciation, are greater than the income it produces for a number of accounting periods, an equity deficit may result. Investors perceive a net equity deficit to be a signal of the company's financial distress. When this occurs, investors can be difficult to come by or cause potential investors to carefully search through the company's balance sheet and income statement to estimate the long-term effect of its financial status.
Billie Nordmeyer is an IT consultant of 25 years standing. As a senior technical consultant for SAP America and Deloitte Touche DRT Systems, a business analyst, senior staff, and independent consultant, Billie has worked across the retail, oil and gas, pharmaceutical, aeronautics and banking industries. Billie holds a BSBA accounting, MBA finance, MA international management as well as the Business Analyst and Software Project Management certificates from the Cockrell School of Engineering at the University of Texas at Austin.