Negative shareholders’ equity is often a red flag for investors and arises when a firm owes more than it owns.Shareholders’ equity is calculated by taking a company's total assets and subtracting its liabilities, or by taking the sum of the issued share capital and retained earnings and subtracting any treasury shares held. When either result is negative, the company has negative shareholders’ equity, meaning nothing would be returned to shareholders if all assets were liquidated and all debts were repaid.
Key Takeaways
- Shareholders’ equity, also called stockholders' equity, represents an ownership interest in a publicly traded company.
- Companies calculate shareholders' equity by subtracting the total liabilities from the total assets.
- Negative shareholders' equity is a warning sign for investors since it suggests the company might be in financial distress and might face bankruptcy.
- Causes of negative shareholders’ equity include accumulated losses over several periods that eroded a firm’s equity base, large dividend payments that depleted retained earnings, or excessive debt incurred to cover losses.
- Shareholders' equity reveals a company’s net worth, a critical measure to consider when investing in a stock.
What Does Negative Shareholder Equity On A Balance Sheet Mean?
How to Calculate Shareholders' Equity
A company’s shareholders’ equity is calculated by deducting total liabilities from total assets:
Total Assets - Total Liabilities = Shareholders' Equity
The information you need for this formula is found in the company’s balance sheet:
- Total Assets: This includes current assets, like cash and accounts receivable, and noncurrent assets, such as property and equipment.
- Total Liabilities: These encompass short-term liabilities like accounts payable and long-term debts such as loans and bonds.
Shareholders’ equity represents a company’s net worth (also calledbook value) and is a gauge of a company’s financial health. If total liabilities exceed total assets, the company will have negative shareholders’ equity. A negative balance in shareholders’ equity is generally a red flag for investors to dig deeper into the company’s financials to assess the risk of holding or purchasing the stock.
Reasons for Negative Shareholders' Equity
A negative balance in shareholders’ equity, also called stockholders’ equity, means that liabilities exceed assets. Here are some common reasons for negative shareholders' equity:
Accumulated Losses
Accumulated losses over several periods or years could result in negative shareholders' equity. In the balance sheet's shareholders' equity section,retained earningsare the balance left over from profits, or net income, and set aside to pay dividends, reduce debt, or reinvest in the company.
After anet loss, the deficit is carried over into retained earnings as a negative number and deducted from any balance left from prior periods. Retained earnings are essentially the cumulative profits a company has earned over its history that have not been distributed as dividends. As a result, a negative stockholders' equity could mean a company has incurred losses for multiple periods, so much that the existing retained earnings and any funds received from issuing stock have been exceeded.
For investors, a negative stockholders' equity is a traditional warning sign of financial instability. It may also affect a company's ability to secure financing or investment. It can also make it difficult for investors to assess the company's financial health using traditional metrics since a negative stockholders' equity can skew important financial ratios like the debt-to-equity ratio.
Large Dividend Payments
Largedividend paymentsthat have either exhausted retained earnings or exceeded shareholders’ equity would produce a negative balance. Combined financial losses in subsequent periods following large dividend payments can also lead to a negative balance.
Cash dividends reduce shareholders' equity on the balance sheet, reducing retained earnings and cash. Companies may issue excessively dividends large for several reasons, each with implications for the firm's financial health and stability.
- A short-term stock boost: Company leaders may believe that higher dividends will temporarily boost stock prices and attract new investors, which benefits those looking to sell their shares.
- Investor expectations: A history of solid dividends may have set expectations high. Investors could perceive reducing or skipping dividend payments negatively, potentially leading to a decline in share prices.
- Competitive Pressure: Firms may issue large dividends to stay competitive with peer companies offering high dividend yields, even if it's not financially prudent for them to do so.
- Overconfidence: Executives may be overly optimistic about future earnings and cash flow, thinking that future performance will easily cover the dividend payout.
- Signal of Health: Companies may use dividends to signal to the market that they are in good financial health, even when underlying issues may exist.
Cash dividends reduce shareholders' equity on the balance sheet, reducing retained earnings and cash.
Borrowing Money
When a company borrows money, it receives cash, which appears on its balance sheet as an asset. But this, of course, also incurs debt, which goes into the balance sheet as a liability. As the company spends the borrowed money, it reduces its assets and lowers its shareholders’ equity unless the business repays its debt.
Issuing new shares to raise funds, rather than borrowing money, could be a strategy for avoiding negative shareholders’ equity since the funds received from issuing stock would create a positive balance in shareholders' equity. However, selling new shares isn't necessarily better than borrowing money. Any time a company issues new shares, itdilutes the outstanding shares, meaning that current owners own a smaller stake in the business, which can cause share values to drop.
Amortization of Intangible Assets
Theamortizationof intangibles,suchaspatents or trademarks,is the process of expensing the cost of an intangibleasset over its projected life. The amortization appears on a company’s profit and loss statement under the expenses category and in the corporate balance sheet in the noncurrent assets section. In certain circ*mstances, if a company already has low or negative retained earnings due to previous losses or excessive dividend payments, the additional amortization expenses can further reduce shareholders’ equity, potentially pushing it into negative territory.
A common way for this to happen is after an acquisition. The acquiring entity records the intangible assets of the acquired company at the fair market value, potentially, for the moment, inflating the company’s assets value. As the intangible assets are amortized, this can overwhelm already low or negative retained earnings, especially for firms that financed an acquisition largely with debt, sinking shareholder equity turn negative.
How Does a Company Operate With Negative Equity?
Many new companies start with negative equity because they've had to borrow money before they can start earning profits. Over time, a company will earn revenue and, hopefully, generate profits, which it can use to pay down its liabilities, reducing its negative equity. If a company cannot do this, then it spells trouble.
What Is the Difference Between Insolvency and Negative Equity?
A company with negative equity has more liabilities than assets but can still pay bills as they come due.Insolvencyoccurs when a company isn't able to do so. This can lead to the company being placed into liquidation
Should You Invest in a Company With Negative Equity?
Negative shareholders' equity is a warning sign that a business could be facing financial distress. A company might have taken on too much debt or could be otherwise overspending. Though companies with negative equity can eventually succeed and grow, investors should closely examine them before investing to understand how they wound up with negative equity, as well as their path forward.
Can a Share Repurchase Cause Negative Equity?
When a company conducts ashare repurchase, it spends money to buy outstanding shares. The cash spent on the repurchase is subtracted from the company's assets, resulting in a shareholder equity drop.
What Are Some Companies That Have Had Negative Shareholders' Equity?
Some major, profitable companies have recently had negative shareholders' equity, including well-known restaurant chains: McDonald's, Starbucks, and Papa John's. The primary driver in these cases may have been issuing massive debt and refranchising or selling corporate-owned stores to franchisees. Most other firms were less healthy, e.g., Lehman Brothers, General Motors, and Hertz Global Holdings had negative shareholders' equity before filing for bankruptcy in 2008, 2009, and 2020, respectively.
The Bottom Line
Negative shareholders' equity could be a warning sign that a company is in financial distress. It’s also possible that a company spent its retained earnings, as well as the funds from its stock issuance, by purchasing costly property, plant, and equipment.
In other words, negative shareholders' equity should tell an investor to dig deeper and explore the reasons for the negative balance.
