What is shareholder equity?

A shareholder is a person who owns shares or equity in a company. This means they reap the benefits when things are good, but will be the last to be compensated if things go wrong. 

Shareholder equity is defined as the amount that will be distributed among the shareholders if a company were to get liquidated. This amount is determined after providing for outside claims on the company’s assets through creditors. Also referred to as net worth, this amount typically suggests what would be left over for the owners of the company once all its external debt obligations are settled.

Shareholders equity explained

There are a few components that shareholder equity includes. 

1. Capital stock reflects the amount paid by investors to the company when it was raising funds. The stock or shares could be preferred or common stock. 

2. Paid-in capital is any surplus capital extended by investors to the company. 

3. Retained earnings contribute to the overall shareholders equity, implying accumulated profits that were not paid back to shareholders and instead kept aside for reinvestment purposes. 

How to calculate shareholder equity

The shareholder equity formula is as follows:

To determine the amount due to shareholders, you will need to take an account of all assets the company currently owns and owes. You must also add all the company’s long-term and current liabilities. Then deduct liabilities from total assets to get the shareholders equity.

Let’s go through a shareholder equity example. Suppose X Ltd is looking to wind down its operations and the investors want to know what they’ll be getting from the company’s liquidation. The total assets and liabilities of X Ltd amount to $5m and $3m, respectively. The shareholders’ equity of X Ltd is $2m.

Relevance of shareholders equity

While in the above example of X Ltd, shareholders’ equity was positive, there could be situations when it is negative. 

Negative shareholders’ equity means that the company’s liabilities outweigh its assets. This can be quite normal for a new business, as it takes some time for a company to begin seeing profits. However, for an established business in a mature sector, negative shareholders’ equity can be a cause for concern. 

Shareholders’ equity also provides a base to calculate different accounting ratios to analyse a company’s performance. The most popular is the return on equity (ROE), which reflects how effectively a company is being managed and provides returns based on the capital put in by investors.