EBITDA And Other Scary Words: Scary Word No.13: "Equity"
January 21, 2020
By Yesenia Cardona, Charles Saydek and William Ryan
It’s now last call for the balance sheet. Our previous articles covered assets and liabilities. Now, we finish the balance sheet and serve up equity. Go all the way back to Scary Word No. 2 – Financial Statements, and you’ll recall the formula of “assets = liabilities + equity.”
If you switch the formula around a little you come up with:
“equity = assets – liabilities.”
Equity consists of stock, additional paid-in capital, retained earnings and some complex items (such as comprehensive income).
Stockholders’ Equity and Members’ Equity
Stockholders’ equity describes the equity for a corporation. Owners of a corporation own shares of stock, which explains why you see this equity described as “stockholders’ equity.”
Members’ equity is used for partnerships and limited liability companies (LLCs) treated as partnerships. Owners of a partnership or LLC own membership units, which explains why you see this equity described as “members’ equity.”
Common and Preferred Stock
Common stock is what we purchase when investing in the publicly traded companies on the stock market. When you make an investment in the stock of a company (like IBM or Amazon), you are purchasing shares of common stock. Owning as little as one share gives you an ownership stake in the company, voting rights, and dividends.
Preferred stock resembles common stock but with additional features. It is called “preferred stock” because it has -- wait for it -- preferences. A dividend preference means dividends get paid to preferred stockholders before common stockholders.
Preferred stockholders may also have a defined dividend amount, while corporate management gets to decide if and how much to pay out in dividends for common stockholders each period. If the company liquidates for any reason, preferred stockholders receive payment before common stockholders.
Preferred stock can also have a conversion feature, which allows the preferred stock to be converted to shares of common stock. Unlike common stock, preferred shareholders do not receive voting rights.
Par Value and Paid-In Capital
Both common stock and preferred stock have a par (stated) value. The par value is usually a small amount, such as $0.01 per share. If you have 100 shares at $0.01 par per share, the total par value would be $1. However, if you paid the company $50 for those 100 shares, you are paid in excess of the par value. The excess, in this case $49, is recorded as additional paid-in capital. Paid-in capital only occurs when you purchase stock directly from the company. If you purchase stock from a third party on a stock exchange, your payment goes to the third party; so, this does not create any additional paid-in capital.
Treasury stock exists whenever a company purchases previously issued shares. The shares purchase is recorded as a reduction of equity. Shares held as treasury stock do not earn dividends or have voting rights. They can be reissued or retired. Retired shares are canceled and can no longer be sold.
Retained earnings is the accumulation of net income. An example company has a net income of $500 in 2014, and a net income of $600 in 2015; so, the retained earnings would be $1,100 at December 31, 2015. Retained earnings fall whenever stockholders receive dividends or whenever members receive distributions.
If company losses, excessive dividends or distributions lead to negative retained earnings it is called accumulated deficit. This also means liabilities exceed assets, and can indicate the company experiences financial difficulties.
Comprehensive income consists of unrealized gains or losses. Increases or decreases in investment market value are unrealized, but need to be reflected in the company’s financial statements. Another common item in comprehensive income is the unrealized gain or loss on foreign currency translation adjustments.
Comprehensive income can get complicated; we’ll save this for a later article, but it’s important to at least be familiar with it.
But, how does all of this relate to our bar?
- The bar is a corporation with four owners. Each owner has 1,000 shares of stock with a par value of $0.01. Four owners, times 1,000 shares each, times par value of $0.01, results in a par value of $40.
- Each owner paid $10,000 for their shares. Four owners, times $10,000 each, less $40 par value, results in $39,960 of additional paid-in capital.
- The bar is pretty successful. Net income for the past three years has averaged $30,000 per year. Three years of net income at $30,000 per year, results in $90,000 of retained earnings.
- The bar previously had five owners but one owner wanted out. The company repurchased her 1,000 shares for $10,000. 1,000 shares repurchased for $10,000, results in treasury stock of $10,000.
- This year the company finally paid dividends of $5,000 to the stockholders. Retained earnings is reduced by $5,000.
Here’s how the equity section of the balance sheet looks after all of the above activity:
Common stock, 5,000 shares authorized,
4,000 shares outstanding, par value of $0.01
Additional paid in capital?
Treasury stock, 1,000 shares
The bar — and our articles — carries on as we leave the balance sheet. Let’s move on to the income statement. Before we do, cheers to the balance sheet!
"This article originally appeared on Financial Poise and is reprinted here with permission."
- EBITDA and Other Scary Words: What Did They Just Say?
- Scary Word No. 1 – GAAP
- Scary Word No. 2 – Financial Statements
- Scary Word No. 3 – Cash
- Scary Word No. 4 – Accounts Receivable
- Scary Word No. 5 – Inventory
- Scary Word No. 6 – PP&E
- Scary Word No. 7 - 'Intangible' Assets
- Scary Word No. 8 - Accounts Payable
- Scary Word No. 9 - Accrued Expenses
- Scary Word No. 10 - Commitments and Contingencies
- Scary Word No. 11 - Debt, Collateral, Covenants, Guarantees and More
- Scary Word No. 12 - "The Deferreds"
- Scary Word No. 13 - "Equity"