Businesses are financed with either debt or shareholder equity. Debt is money loaned from various lending institutions, such as banks. Shareholder equity is money contributed by shareholders in exchange for an ownership interest in the company. There are two primary categories of shareholder equity. The more frequently used type is common stock, and the other type is preferred stock.
The debt/equity ratio is commonly used by investors to measure the relative values of debt to shareholder equity. The ratio is simply calculated by dividing the total debt in a company by the total amount of shareholder equity. Investors use this ratio to help determine the financial health of a corporation, with less debt and more equity typically being seen as a healthier corporation.
Repayment in Default
One characteristic of shareholder equity is that it gets repaid after debt in the event of a dissolution. In other words, if a corporation goes out of business and sells its assets worth $100 million and debts worth $120 million, all of those debts would be repaid before any shareholders would be given money. In this case, that would mean that the shareholders would get no money because the debts outweigh the available assets. If there is both preferred and common stock, preferred shareholders get repaid before the common shareholders.
Shareholder equity is a form of ownership in the company, meaning that equity shareholders literally own the company. This means that if a corporation wants to issue new shares of equity, it must do so by diluting the ownership of the current shareholders. For this reason, many shareholders are wary of issuing new classes of equity.
In addition to ownership rights, shareholder equity may also entitle its holder to a right to vote on certain aspects of the company, including the ability to vote for the composition of the company's board of directors. Preferred stock does not carry this voting right, whereas common stock does carry a voting right. The rule is generally one share, one vote.