Stockholders' equity definition
/What is Stockholders’ Equity?
Stockholders' equity is the amount of assets remaining in a business after all liabilities have been settled. It is comprised of common stock, preferred stock additional paid-in capital, retained earnings, and treasury stock.
How to Calculate Stockholders’ Equity
Stockholders’ equity is calculated as the capital given to a business by its shareholders, plus donated capital and earnings generated by the operation of the business, less any dividends issued. On the balance sheet, stockholders' equity is calculated as follows:
Total assets - Total liabilities = Stockholders' equity
An alternative calculation of stockholders' equity is:
Share capital + Retained earnings - Treasury stock = Stockholders' equity
Both calculations result in the same amount of stockholders' equity. This amount appears in the balance sheet, as well as the statement of shareholders' equity.
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How to Interpret Stockholders’ Equity
The stockholders' equity concept is important for judging the amount of funds retained within a business. A negative stockholders' equity balance, especially when combined with a large debt liability, is a strong indicator of impending bankruptcy. However, this situation may also arise in a startup business that is incurring losses while it develops products to bring to market. A startup business typically experiences a decline in its stockholders’ equity until its products become profitable, after which the inflow of profits boosts its retained earnings balance.
Stockholders’ Equity Accounts
A number of accounts comprise stockholders' equity, which are noted below.
Common Stock
Common stock is the par value of common stock, which is usually $1 or less per share. In some states, par value may not be required at all. The bulk of all shares sold will typically be comprised of common stock.
Additional Paid-In Capital
Additional paid-in capital is the additional amount that shareholders paid for their shares, in excess of par value. The balance in this account usually substantially exceeds the amount in the common stock account, since par value may be set as low as $0.01 per share.
Retained Earnings
Retained earnings is the cumulative amount of profits and losses generated by the business, less any distributions to shareholders. This balance will fluctuate over time, especially if cash reserves are being drained away by issuing dividends or buying back shares from investors.
Treasury Stock
The treasury stock account contains the amount paid to buy back shares from investors. The account balance is negative, and therefore offsets the other stockholders' equity account balances.
Stockholders’ Equity vs. Book Value
Stockholders' equity can be referred to as the book value of a business, since it theoretically represents the residual value of the entity if all liabilities were to be paid for with existing assets. However, since the market value and carrying amount of assets and liabilities do not always match, the concept of book value does not hold up well in practice.
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