Shareholders’ equity usually represents the difference between a company’s total assets minus the total liabilities. This number also indicates the total economic value the company has generated using its assets and other resources. While corporations commonly refer to this number as shareholders’ equity, private business organizations and small businesses often call this number net worth or owner’s equity, respectively. This number has a significant meaning in the business environment since it represents the amount of money investors would be paid when cashing out their investments or when the company liquidates its assets.
Two main sources represent shareholders’ equity. The original money represents investments made by businesses, investment firms, and individuals. While businesses and investment firms can make direct capital investments into a company, individuals often purchase preferred or common stock when making equity investments. The second source of this equity is the retained earnings listed on the balance sheet. Retained earnings represent all monthly income reinvested into business operations. This number is reported on a company’s balance sheet as a running total for all money retained by the company since it began business operations.
Companies may decide to offer dividend payments for all individuals holding preferred stock. Preferred stock investments are usually the only investments or shareholders can earn dividend payments. Common stock investments forgo dividends in lieu of voting rights on various business situations. Dividend payments reduce the overall amount of shareholders’ equity retained in the firm. Investors often invest in preferred stock in order to receive monetary benefits earlier rather than later.
Investors often use the shareholder equity ratio to calculate the amount investors would receive in the event of a company liquidating its assets and ceasing operations. This number is important because shareholders commonly lose their entire investment if a company declares bankruptcy. This formula is calculated by dividing total shareholders’ equity (total assets minus total liabilities) by the total assets owned by the company. This ratio is expressed as a percentage when using this formula.
For example, if the company has a 30% shareholder equity ratio and total assets of $225 million United States Dollars (USD), investors would receive $67.5 million USD as their part of the liquidation process. The entire $67.5 million USD would then be a portion to each individual investor based on their equity investment in the company. This allocation process can be long and arduous, depending on the number of investors and financial assets sold during the liquidation process.