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What is Shareholders’ Equity?
By definition, Shareholders’ Equity, or Stockholders’ Equity, is the net worth of a company's shareholders after all debt has been repaid. The amount is disclosed on a firm's balance sheet and is equal to the sum of contributed capital plus retained earnings.
As discussed in our balance sheet guide, the statement of financial position is known as a balance sheet because it is maintained to ensure that a company's assets are always equal to the sum of liabilities and shareholders’ equity. Thus, investors can get to shareholders’ equity by applying the balance sheet equation, that is:
Shareholders’ Equity = Assets - Liabilities
Shareholders’ Equity Example
Now that you know what stockholders’ equity is, let's take a look at Apple's 2019 balance sheet to get a real example of shareholders' equity. As depicted below, it consists of common stock and additional paid-in capital (share capital), and retained earnings. You can also observe that both total assets and liabilities plus stockholders' equity are equal to 338,516 million.
Source: Apple's 10K, Oct 31, 2019
Share Capital
As anticipated above, the main components of shareholders' equity are contributed capital and retained earnings. Share capital consists of the amount of money invested by stockholders. For example, if an entrepreneur starts a company investing $1 million, cash (asset) grows by $1 million, and share capital (on the shareholders' equity) goes up by the same amount.
Businesses can increase their share capital by issuing additional common stocks or preferred stocks. However, if a company issues new shares of stock, it reduces existing shareholders' proportional ownership. This mechanism is known as share dilution, a problem that every company looking for funding must pay attention to.
As depicted in Apple's balance sheet above, the shareholders' equity section on the balance sheet can include some other share-related terms, such as:
- Shares authorized is the maximum number of shares the company can issue under its articles of incorporation.
- Shares issued are the total number of shares issued by the company.
- Shares outstanding are the shares owned by external investors.
- Treasury shares are the shares owned by the issuing company.
As you can guess, the number of treasury shares is equal to the difference between shares issued and shares outstanding. The following graph summarizes the relationship between the different types of shares.
Retained Earnings
The retained earnings account on the shareholders' equity section of the balance sheet consists of a company’s earnings that are not distributed as dividends to shareholders but are retained to invest and self-fund the company's growth.
Firms calculate retained earnings using the following formula:
Retained Earnings = Beginning Period Retained Earnings + Net Income/Loss – Dividends Paid
Shareholders’ Equity Example Calculation
To illustrate, we can use the shareholders' equity formula to calculate Microsoft's (MSFT) stockholders' equity. Using the Finbox data explorer, we can find the values of the metrics required to apply the formula:
- Microsoft's Total Assets = $301B
- Microsoft's Total Liabilities = $177.69B
We can now calculate Microsoft's shareholders' equity by subtracting total liabilities from total assets:
MSFT's Shareholders’ Equity = MSFT's Total Assets - MSFT's Total Liabilities
MSFT's Shareholders’ Equity = $301B - $177.69B = $123.31
Negative Shareholders’ Equity
Stockholders’ equity can be positive or negative. A positive shareholders’ equity indicates that the business can cover its liabilities with its own assets. In other words, the company's assets are greater than the company's liabilities.
On the other hand, a negative shareholders’ equity is a warning sign that indicates that the firm's total liabilities exceed total assets. This is an unsustainable capital structure that can lead to the company's bankruptcy in the long term.
