Shareholder's equity is one of the key areas of the balance sheet to analyze. It gives an investor an idea of how successful the company has been since it began operation. Usually, a strong company would have a large balance in stockholder's equity. However, a negative stockholder's equity does not necessarily mean that the company has been a bad performer.
Stockholder's equity is the cumulative net capital contributions shareholders have made to a company. It is part of the most basic accounting equation that states that assets equal liabilities plus shareholder's equity. Shareholder's equity is found on the balance sheet and calculated by subtracting liabilities from assets. For example, a company has assets of $100 million and liabilities of $50 million. The shareholder's equity is simply $100 million of assets minus $50 million of liabilities for a total of $50 million. A number of accounts make up the shareholder's equity section, including paid-in capital, additional paid in capital and retained earnings.
A negative stockholder's equity can mean a number of things, including that the company has been successful in returning capital to shareholders and has returned more capital than was paid in and contributed to the company. For example, a corporation was established two years ago with a equity contribution of $1 million. The company generated retained earnings of $2 million for the two years. The company then decided to issue a $4 million dividend to stockholders. The balance on the accounts would be $1 million in paid-in capital and a negative $2 million in retained earnings. The stockholder's equity balance would be a negative $1 million. Dividends are paid out of retained earnings, and that's why the account would be negative.
A company may also have a negative stockholder's equity if it has been successful and decided to return capital to shareholders through the use of share repurchases. For example, a company began operations two years ago and started out with equity capital contributions of $1,000. The company generated retained earnings of $1,000 combined in the two years. The company then repurchased $3,000 worth of shares. The balance in the accounts would be $1,000 in paid-in capital, $1,000 in retained earnings and $3,000 in treasury stock for a net balance of stockholder's equity of negative $1,000.
Another option is that the company has been underperforming and the losses it has accumulated are more than the capital contributed to the company. For example, a company was started two years ago with an equity capital contribution of $1,000. In its first two years of operations, the company accumulated losses of $2,000. The journal entry for that would be paid-in capital of $1,000 and retained earnings of negative $2,000. The balance for stockholder's equity would be a negative $1,000.