What Is Shareholders’ Equity – Overview, Components and How To Calculate

Reading Time: 5 minutes

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:

Also Read on FinMedium:  Annual Report Review of Crompton Greaves Consumer Care – Factsbeyondnumbers
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.

Retained earnings

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.

Also Read on FinMedium:  Guide on Index Fund 2021 – Meaning, Risks, Returns, Why and How To Invest

Treasury stock

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:

Formula #1

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.

Formula #2

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
Outstanding payments 4,00,000 Debtors  10,00,000
Creditors  2,50,000 Cash  1,50,000
Total  86,50,000 Total 86,50,000

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.

Also Read on FinMedium:  Coromandel International - Best Agriculture Stock to Buy?

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.


Your go-to investment analysis platform


Latest posts by Tickertape (see all)

Source link

Disclaimer: The opinions expressed in this publication are those of the authors. They do not purport to reflect the opinions or views of the FinMedium or its members. The presentation of material therein does not imply the expression of any opinion whatsoever on the part of the FinMedium concerning the legal status of any company, country, area, or territory or of its authorities. For more info. please read our ToU & Privacy Policy here. If you have any concerns regarding this post, please reach out to our grievance officer Ghanisht Nagpal and drop a mail to editor@finmedium.com

Every Wednesday and Saturday, we send Info-Graphic and FinMedium Weekly Digest newsletters to our 25000+ Subscribers.

Join Them Now!

Ticker Tape

Ticker Tape

Ticker Tape shares useful Data, Information & Content on Indian Stocks, ETFs & Indices.
Please Share Now :)

Leave a Reply

Your email address will not be published. Required fields are marked *