What Is The Purpose Of Shareholder’s Equity

Custom Text

The financial industry, especially compared to most other industries, is overflowing with jargon. Financial analysts love to throw out plenty of buzzwords and ratios that go along with their analysis. One buzzword that is very commonly used is shareholders’ equity. It’s likely that you’ve seen this word pop up a few times but might not be entirely sure what it means.

Let’s take a closer look at what shareholders’ equity is as well as the purpose that it serves.

What is shareholders’ equity?

Shareholders’ equity, also known as stockholders’ equity, is the amount of equity that is leftover in a company after all of that company’s debts and liabilities have been paid.

To get a sense of how shareholders’ equity works, imagine the process of buying a house. To start, you put a down payment down on the house and then borrow the rest of the money from a bank. This means that you start out with very little equity and the house is mainly financed with debt. However, over time you will slowly pay off this debt. At the same time, the value of the home may also rise. Over time, your equity in the home and debt will flip flop until the home is entirely equity made up of equity.

Money Masters

Shareholders’ equity is very similar except instead of a home and a mortgage, you evaluate the business’ assets and liabilities. Shareholders’ equity can fluctuate based on the performance of the business.

In total, there are four components that are included when calculating shareholders’ equity:

  1. The number of outstanding shares of stock – The amount of stock that has been sold to investors and not repurchased by the company.
  • Additional paid-in capital – The amount of money paid for shares of stock above the par value.
  • Retained earnings – Earnings that a company simply holds onto instead of paying out as dividends. A company will usually use these to pay off debt or reinvest in the business.
  • Treasury stock – Shares of stock that have been repurchased by the company.

So how do investors use this information when evaluating a stock?

How is shareholders’ equity valuable?

Shareholders’ equity is a great measure when trying to determine the financial health of a company. If a company has a lot of shareholders’ equity then it basically means that the assets that company owns far outweighs any liabilities or debt. On the other hand, a negative shareholders equity means that a company has significant debts on its balance sheet. If this business does not perform well then it could default on its debts and go out of business.

This metric is also valuable when calculating the book value of a company. Essentially, it is one of the simplest ways to assess how a company is performing. To calculate the book value per share of stock, you simply take shareholders’ equity and divide it by the number of shares outstanding.

We hope that you’ve found this article valuable when it comes to learning what the purpose of shareholders’ equity is. If you’re interested in learning more please subscribe below to get alerted of new articles as we write them!

Comments

Custom Text

SUBSCRIBE TO OUR NEWSLETTER