Quora Answer: Why Should I be Concerned about Shareholder Equity?

The following is my answer to a Quora question: “Why should I be concerned about shareholder equity?”

Shareholder equity is the residual claim by the owners of the company less debts.  Simplistically, it is the difference between total assets and total liabilities.  Shareholder equity is not the same as company equity, which is the level of asset ownership.  For example, if the stock is worth $100 million, and $50 million was borrowed to buy the stock, the actual equity level is $50 million, or 50%.  As the debt is paid off, the equity level rises.  Unlike shareholder equity, equity refers to specific assets, which normally means shares, and the level of ownership specific to it.

Shareholder equity is a basic metric to measure the financial health of a company, and its viability.  It is taken to represent the net value or book value of a company.  This is important, because shareholder equity may either be positive or negative.  Negative shareholder equity means that the company has more liabilities than assets.  And if this is the situation over an extended period of time, comprising several accounting periods, the balance sheet of the company is considered insolvent.  The company cannot function as a going concern, and is essentially bankrupt.  This makes the company a risky investment.

That being said, shareholder equity alone does not always tell the full story of the company’s financial health.  It is solely the difference between asset and liability, and does not take into account revenue.  Should a company with an insolvent balance sheet close a huge project that guarantees a major revenue stream, it will take time for it to be reflected in the balance sheet.

Also, when considering shareholder equity, retained earnings in the form of dividends paid out and the amount reinvested should be reasonable.  If the dividend paid out is significantly more than the amount reinvested, the company is being hollowed out and the directors and shareholders are, for want of a better term, looting it.  That is not a good company to invest it, because we cannot be sure of the business as a going concern.

Shareholder equity is also used to calculate the return on equity.  Return on equity is the company’s net income divided by the shareholder equity.  It is the relationship between the returns generated, and the total amount invested by equity investors.  This tells us how much of the equity raised from investors buying the shares is used to generate a profit, and conversely, how much is wasted.

In the event that a business may seem to be failing, it is an indication of how much of that money will be returned should all assets be liquidated to pay debts.  Bankrupt does not always mean absolutely broke.