Many companies raise capital by issuing shares to investors. When investors invest in the shares issued by the company, they not only contribute to the company’s share capital, they also own a stake in the company. The share capital gives the company a permanent source of funding. It is paid back to the equity shareholders at the time of the company’s liquidation.
In the meanwhile, shareholders can assess the sufficiency of the company’s assets by checking the shareholders’ equity. Shareholder equity is an important financial yardstick to measure the company’s financial performance. Let’s understand what it is all about.
This article covers:
What is shareholders’ equity?
Shareholders’ equity is the amount that shows a company’s residual assets to pay back its shareholders. Also known as stockholders’ equity, it is the fund left for the shareholders after the company pays back all of its debts.
If you look at it from a mathematical point of view, shareholders’ equity can be denoted as the company’s total assets minus the total liabilities. In other words, it is the assets that remain to pay back the company’s equity shareholders when all the debts have been paid off at the time of liquidation.
Components of shareholders’ equity
To calculate shareholders’ equity or shareholders fund, you need to know the main components that constitute it. These main components include the following:
The share capital
When we talk about the share capital, we have to consider both its components:
1. The outstanding share capital: This amount denotes the capital raised by issuing shares to the public. So, if the company issues 1 lakh shares to the public and each share is valued at Rs 10, the outstanding share capital would be: 1 lakh x Rs 10 = Rs 10 lakh. When calculating the outstanding share capital, you need to consider the share’s book value or par value, not the market value. Moreover, you should calculate the outstanding share capital for both equity shares and preference shares. For example, consider the following share capital of a company:
|Type of shares||Par or book value||Current market value|
|Equity shares (1 lakh shares)||Rs 10||Rs 15|
|Preference shares (50,000 shares)||Rs 15||Rs 20|
The outstanding share capital would be calculated as follows:
Outstanding equity share capital = Rs 10 x 1 lakh = Rs 10 lakh
Outstanding preference share capital = Rs 15 x 50,000 = Rs 7.5 lakh
Total outstanding share capital = Rs 17.50 lakh
2. Additional paid-in capital: If the company’s shares were issued at a premium, the difference between the book value and the cost at which the shares were subscribed is called the additional paid-in capital. For example, say a company is issuing 1 lakh shares with a book value of Rs 100 each at Rs 120. So, each share is being issued at a premium of Rs 20. In this case, the additional paid-in capital would be Rs 20 x 1 lakh = Rs 20 lakh.
When the company earns a profit, it retains a part of the profit within the business for growth and expansion. The remaining amount of profit is, then, distributed among shareholders. This retained profit is also called retained earnings.
For example, if a company earns a profit of Rs 1 cr in a year and distributes Rs 40 lakh in dividends, it retains a profit of Rs 60 lakh which is called the retained earnings. Retained earnings are added to the share capital in the calculation of shareholders’ equity because they form a part of the shareholders’ fund.
Companies often buy back some of their outstanding shares from their shareholders. The shares bought back are called treasury stock. They reduce the shareholders’ equity and are, thus, subtracted from the value of the share capital when calculating shareholders’ equity.
Calculation of shareholders’ equity
There are two main formulae that you can use to calculate the shareholders’ equity. These formulae are highlighted below:
Shareholders’ Equity = Total assets – Total liabilities
Interpretation: In this formula, all the assets of the balance sheet are summed up and all the liabilities, current and long term, are also summed. The excess of assets over liabilities is the shareholders’ equity.
Shareholders’ Equity = Share capital + retained earnings – treasury stock
Interpretation: In this formula, you use the components of shareholders’ equity to find the value. Take the outstanding share capital of the company, add the retained earnings, and deduct the share buybacks to find out the shareholders’ equity.
Now that you know both the formulae, let’s calculate the shareholders’ equity using them. Here’s a sample balance sheet of a company:
|Liabilities||Amount (Rs)||Assets||Amount (Rs)|
|Share capital||50,00,000||Land and building||35,00,000|
|Retained earnings||10,00,000||Plant and machinery||25,00,000|
|Long term debt||20,00,000||Stock||15,00,000|
Calculation of shareholders’ equity
- Formula #1: total assets – total liabilities = Rs 86,50,000 – Rs 26,50,000 = Rs 60,00,000
- Formula #2: share capital + retained earnings – treasury stock = Rs 50,00,000 + Rs 10,00 000 – 0 = Rs 60,00,000
So, whichever formulae you use, the result would be the same!
What does shareholders’ equity denote?
If the assets of the company exceed its liabilities, the shareholders’ equity would be a positive figure. This would depict that the company has excess assets that can be used to pay back the shareholders. On the other hand, if the shareholders’ equity is a negative figure, it means that the company’s liabilities exceed its assets, a scenario that is not favourable. If the shareholders’ equity remains negative for consecutive years, the company faces a danger of liquidation. Thus, for prospective and existing investors, this is a red flag.
When you invest in a company, an assessment of its shareholders’ equity would give you an idea of whether the company has strong financials or not. Thus, shareholders’ equity can help investors make the right investment decisions. Moreover, for computing the return on equity, shareholders’ equity is an important component. It, therefore, helps investors assess how effective the company is in using its share capital to generate returns.
The shareholders’ equity is, therefore, an important component of a company’s balance sheet which is used by investors, along with other financial details to make investment decisions. You can also check out a company’s shareholders’ equity either when you are investing or if you are an existing investor to get an idea about the company’s financial future.