Negative Equity Meaning
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. Take, for instance, ABC Limited has $50 million of total liabilities and $30 million of total assets. Negative equity for ABC Limited= $50 million – $30 million= $20 million
The potential indebtedness for ABC Limited is $20 million.
Interpretation of Negative Equity
It occurs when a company’s debt is higher than its assets. It is a scenario that depicts potential indebtedness for an organization as a result of 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. 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..
It is applicable for not just organizations but for individuals too. For example, individuals who own a house may find themselves facing it in case their home loses value. It means they might owe a higher amount to the bank as compared to the amount the house is worth.
It is always important to find out whether there is negative equity or not. 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. 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 amount of 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 it?
It 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 the total value of assets. In the second step, one must subtract the total value of assets from the total value of liabilities.
Negative Equity = Total Value of Liabilities – Total Value of Assets
Example of Negative Equity
Bill’s overall value of liabilities is $60 million, while his overall value of assets is $40 million. Find Bill’s equity.
- = $60 million – $40 million
- Negative Equity for Bill = $20 million
Reasons for Negative Equity
- 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 mortgage payments 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 that were already in large debts suffered from it since their residential property was way lesser than it was 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 single month, and in return, 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 price of the property falls.
How to Get Away with Negative Equity?
- Less Reliance on Debts – Higher reliance on debts could bring a lot of trouble. Reliance on debts 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 probabilities of it and, thus, insolvency.
- Stay Determined – It may not be easy for many people to pay off their mortgage all at once. Hence, this may be a little depressing for them, and they might feel like giving up. But instead of being too harsh on oneself, it is best advised 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 get rid of their assets by disposing of the same and repaying all the mortgages.
Negative Equity takes place 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 with respect to outstanding balance left on 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. are two different concepts since the latter states that the trouble has already arrived while the former states that trouble is about to arrive.
This article has been a guide to Negative Equity and its Meaning. Here we discuss how to calculate negative equity along with a practical example, its reasons, and interpretations. You can learn more about financing from the following articles –