Negative Equity

Updated on April 30, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Negative Equity?

A negative balance in shareholders’ equity reflects that liabilities have outgrown the assets for reasons like accumulated losses over the years, large dividend payments, money borrowed instead of issuing new shares to cover accumulated losses, amortization of intangibles, etc.

What Is Negative Equity

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In such cases, the equity line item will show a negative balance on the balance sheet. Thus, the loss the entity has incurred has offset any earnings. This indicates that the company can go bankrupt due to poor financial conditions. However, it might also mean it is making many expansions or investments to help earn revenue in the coming years.

How Does Negative Equity Work?

Negative Equity occurs when the total value of liabilities exceeds the total value of assets. It reflects potential indebtedness. And it occurs when the number of assets owned is insufficient for securing a loan concerning the outstanding balance left on the loan. Negative equity and insolvencyInsolvencyInsolvency is when the company fails to fulfill its financial obligations like debt repayment or inability to pay off the current liabilities. Such financial distress usually occurs when the entity runs into a loss or cannot generate sufficient cash flow.read more are two different concepts since the latter states that the trouble has already arrived while the former states that trouble is about to arrive.

However, negative equity on balance sheet does not always mean the company is in trouble. It may even have negative equity temporarily due to heavy expansion or investments. These generally do not show the yield in the current year, but the positive effect is reflected in the balance after a few years when such investments start giving returns.

At an individual level, there may be negative equity value where the assets are less than liabilities resulting from a fall in the asset value due to depreciation of price fluctuations. The amount of loan may also increase due to nonpayment.

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Interpretation

Negative equity on balance sheet occurs when a company’s debt is higher than its assets. It is a scenario that depicts potential indebtedness for an organization due to its higher reliance on debts. Accumulated losses over the years can also result in negative equity, as these losses will be carried over and reflected as retained earningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more in the company’s balance sheetCompany's Balance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company.read more.

It is applicable for not just organizations but for individuals too. For example, individuals who own a house may face it in case their home loses value. It means they might owe a higher amount to the bank than the amount the house is worth.

It is always important to determine whether there is negative equity value. It can cause trouble for the seller and the buyer too. For example, an individual bought a car on a loan, which is not yet repaid. The individual had opted for the insurance long back. As a result, the value of the car has diminished. In such a scenario, the individual may not get enough money from the insurance company to repay the leftover loan. And, if the individual cannot get rid of the negative equity lying on his car, then the insurance company would be liable to pay that debt lying in the car.

How To Calculate?

Negative-Equity Formula

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Negative equity in company can be calculated by deducting the value of assets from the value of liabilities. In the first step, one must determine the total value of liabilities and assets. Then, in the second step, one must subtract the assets’ total value from the liabilities’ total value.

Negative Equity = Total Value of Liabilities – Total Value of Assets

Example

Bill’s overall value of liabilities is $60 million, while his overall value of assets is $40 million. Find Bill’s equity.

Solution

Negative Equity Example 1
  • = $60 million – $40 million
  • Negative Equity for Bill = $20 million

Cause

Let us understand what causes the negative equity in company or in case of individuals.

  • Over Borrowings – Opting for a new mortgage or home loan can also pave ways for negative equity in individuals. Higher the borrowings, higher shall be the probabilities of potential indebtedness. The more one has to pay back, the greater the risk for house prices to slope down
  • Failure to Timely Pay Mortgage Payments – Failure to pay or missing mortgage payments can also put an individual at risk of it. However, this alone cannot be a reason for it. It could be an add on reason leading an individual or organization towards it.
  • Diminishing House Prices – This is one of the most prominent causes of negative equity. In the year 2008, when the house prices crashed and the financial credit crisis went up, homeowners already in large debts suffered from it since their residential property was way lesser than before the crash of house prices.
  • Interest-Only Mortgages – An interest-only mortgage is a scenario where one has to make payments on the interest on his or her loan every month, and the debt will not reduce. Such types of mortgages are highly risky, and these can easily put an individual or an organization in a state of negative equity if all the property price falls.

How To Get Out Of Negative Equity?

Let us look at how to get rid of risk of negative equity.

  • Less Reliance on DebtsNegative equity in company can result from higher reliance on debts, which could bring a lot of trouble. Dependence on debt is one of the most prominent reasons. Therefore, there must be minimal or zero reliance on debts, and one must focus more on other options to tackle the probabilities of it and, thus, insolvency.
  • Stay Determined – It may not be easy for many to pay off their mortgage immediately. Hence, this may be depressing for them, and they might feel like giving up. But instead of being too harsh on oneself, it is best to take one step at a time and repay the entire mortgage slowly.
  • Seek Professional Advice – Seeking expert advice can also get an individual or organization out of this situation.
  • Sell and Repay – One can also eliminate their assets by disposing of the same and repaying all the mortgages.

The above detail clearly states how to get rid of risk of negative equity.

This article is a guide to what is Negative Equity. We explain how to calculate it and get out of it along with example, causes and its interpretation. You can learn more about financing from the following articles –

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