Negative Shareholders Equity refers to the negative balance of the shareholders equity of the company which arises when the total liabilities of the company are more than value of its total assets during a particular point of time and the reasons for such negative balance includes accumulated losses, large dividend payments, large borrowing for covering accumulated losses etc.
Negative Shareholders Equity
Have a look at Colgate’s Shareholders Equity. Its Shareholders’ Equity is Negative.
Is Negative Shareholder’ equity a danger sign, implying investors to stay away from this stock? Negative Shareholder’ equity is, in most cases, due to losses accumulated over the years by the company.
In this article, we look at negative shareholder’s equity in detail –
- What is Negative Shareholder’s Equity?
- How Does Negative Shareholder’s Equity Occur?
- Negative Shareholder’s Equity – Revlon
- Negative Shareholder’s Equity – Colgate
- Negative Shareholder’s Equity – HP
- Implications of Negative Shareholders equity
- Does Negative Shareholders Equity Imply Zero Market Value?
What is Negative Shareholder’s Equity?
Let us first go back to the basic accounting equationBasic Accounting EquationAccounting Equation is the primary accounting principle stating that a business's total assets are equivalent to the sum of its liabilities & owner’s capital. This is also known as the Balance Sheet Equation & it forms the basis of the double-entry accounting system. . Shareholder’s equity is simply the difference between Assets and Liabilities.
In other words, it is the amount of capital that the proprietor brings in when the business is started. In the case of a company, it is the amount of capital the shareholders subscribe to.
As shown above, equity is the portion of the difference between the assets and liabilities. It also includes reserves that are accumulated over some time through profits.
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On the other hand, Negative equity refers to the negative balance of equity share capitalShare CapitalShare capital refers to the funds raised by an organization by issuing the company's initial public offerings, common shares or preference stocks to the public. It appears as the owner's or shareholders' equity on the corporate balance sheet's liability side. in the balance sheet. This situation usually happens when the company has incurred losses over a continuous period such that they offset the reserves and equity capital appearing on the balance sheet.
It can happen because of the number of other reasons too. The following are the major reasons for negative equity.
- The company is over-leveraged, which means that there is a huge amount of debt. When a company incurs losses, this results in cash outflow. So, the company generally borrows to stay and operate. This circle goes on, which generally results in a huge pile-up of debt, and the company is incurring losses. Additionally, once a company enters this phase of negative equity, it results in the downgrade of credit ratings, which further results in higher interest rates.
- Treasury Stock Repurchase – As per the company’s stock repurchase plan, the company may buy its common stocks. It results in the reduction of Equity. If large amounts of common stock are repurchased, then it can lead to negative shareholder’s equity.
- Dividend Payments – If the company has paid more amounts of cash dividendsCash DividendsCash dividend is that portion of profit which is declared by the board of directors to be paid as dividends to the shareholders of the company in return to their investments done in the company. Such a dividend payment liability is then discharged by paying cash or through bank transfer. than the profits it earned, it can result in negative shareholder’s equity.
- Creation of Provisions – Negative shareholder’s equity can also happen when the company has created large provisions for the future expected Financial LiabilitiesFinancial LiabilitiesFinancial Liabilities for business are like credit cards for an individual. In simple terms, a financial liability is a contractual obligation that needs to be settled in cash or any other financial asset and are very useful in the sense that the company can employ “others’ money” in order to finance its own business-related activities for some time period which lasts only when the liability becomes due. The liabilities could be of two types, short term and long term..
Also, note that negative retained earnings do not necessarily mean that the shareholders have to give money to the company. Under the company laws, shareholders are liable only to the extent that the money they invested in the business.
In the case of negative equity companies, if they liquidate or dissolve, shareholders probably receive nothing in exchange for the investment they made initially. However, if the company realized more amounts by selling its assets, it may pay shareholders even though there is negative equity.
How Does Negative Shareholder’s Equity Occur?
Let me explain this concept to you with the help of an example.
Mr.X wants to start the business of steel coils. He bought $1,00,000 from the bank as a loan and $50,000 as his contribution. Now he purchased assets for establishing the business US$ 25,000 for buying a building and godown and $5,000 for furniture, US$ 60,000 for purchasing steel stocks (inventory). Rest US$ is in Cash. Now, all set, so he went to start the business. His opening balance sheet appears as follows.
So, he eventually started the business, started selling steel. Due to the difficult business environment, the steel prices starting to fall, and he could sell his inventory of $60,000 at a $35,000, incurring a loss of $25,000.
Additionally, he took an additional loan of $40,000 and bought a stock of $80,000.
Cash Balance = $60,000 (opening) + $35,000 (sale of steel inventory) – $80,000 (new stock) = $55,000
The closing balance sheet is as follows.
In the above case, Assets- Liabilities is 1,65,000-1,40,000 which is US$ 25,000 whereas Shareholders Equity is 25,000
Now let’s move on.
In the next year 2017, the prices fell further. The stock of US$ 60,000 is sold for only US$ 25,000, at a loss of US$ 35,000.
Reserves and SurplusReserves And SurplusReserves and Surplus is the amount kept aside from the profits that are to be used either for the business or for the shareholders to pay out dividends. Reserves and surplus is reflected under shareholders funds in the balance sheet. = -$25000 – $35000 = -$60000
Total assets, in this case, is US$ 1,30,000, whereas liabilities are US$ 1,40,000, making shareholders equity negative.
Negative Shareholder’s Equity – Revlon
See the following balance sheet of American Multinational cosmetics company, Revlon incorporation 2013.
source: Revlon SEC Filings
As you see in the above snapshot, there is a huge amount of negative retained earnings (accumulated deficit) in the Revlon balance sheet, which is leading to negative total equity. The negative retained earnings are mainly because of consistent losses from its operations, especially due to slowdown in its Chinese market.
Revlon’s total assetsTotal AssetsTotal Assets is the sum of a company's current and noncurrent assets. Total assets also equals to the sum of total liabilities and total shareholder funds. Total Assets = Liabilities + Shareholder Equity were US$3023 mn, whereas its liabilities were around US$ 3,638 mn resulting in Shareholder’s equity deficit of US$ 614.8 mn.
Negative Shareholder’s Equity – Colgate
Let us now have a look at the Shareholder’s Equity section of Colgate. Please note that Colgate is a profitable company with retained earnings of $19.9 billion in 2016.
Yet, its shareholder’s equity is negative due to two reasons –
- Treasury Stock – As per its share repurchase plan, Colgate buybacks its share each year. We note that Colgate has bought $19.13 bn of common stock until 2016.
- Accumulated other comprehensive income – This is another reason why Colgate’s shareholder’s equity is negative. Each year, other comprehensive losses increase the losses even further. (For details, look at Accumulated other comprehensive income)
Consolidated Statement of Changes in Shareholder’s equity provides us with comprehensive details of the Shareholders Equity section. Please see below Colgate’s Consolidated Statement of Changes in EquityStatement Of Changes In EquityStatement of changes in equity is the adjustment of opening and closing balances of equity during a particular reporting period. It explains the connection between a company’s income statement and balance sheet. It also includes all those transactions not captured in these two financial statements..
We note that in 2016, Colgate repurchased $1.55 billion worth of common stocks. Also, other comprehensive losses net of taxes was -$230 million in 2016.
source: Colgate SEC Filings
Negative Shareholder’s Equity – HP
Let us now have a look at the shareholder’s equity section of HP. We note that in 2015, HP’s shareholder’s equity was $27.76 billion, whereas, in 2016, it turned negative to -$3.88 billion. Why?
source: HP 10K filings
The primary reason for HP’s Shareholder’s Equity going negative was changes in Retained Earnings. Please note that the changes in 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 HP was not because of losses as HP. HP is profitable and reported Net earnings of $2.49 billion in 2016.
HP’s Shareholder’s Equity turned negative due to its Separation of HP Enterprise that led to the reduction of shareholder’s equity of -$37.2 billion. Additionally, negative shareholders’ equity was further compounded by the cash dividends of $858 million.
Implications of Negative Shareholders equity
- Increased interest rates by banks
- Difficulty in getting further funds either through loans or equity
- Reduction in credit periodCredit PeriodCredit period refers to the duration of time that a seller gives the buyer to pay off the amount of the product that he or she purchased from the seller. It consists of three components - credit analysis, credit/sales terms and collection policy. offered by creditors, or they may deny credit sales.
- Decrease in corporate valuations and credit ratings
- Decrease in orders as the customers fear for the company honoring the contract
- Unable to pay dividends to shareholders
- Fall in company stock price
- Company may be classified as per laws as a sick company
- May result in employee lay off’s, which may result in the degradation of company name & fame and employee morale.
Does Negative Shareholders Equity Imply Zero Market Value?
Just because the equity in the company books is negative, that doesn’t mean that the company share price in the market is zero or available for free. The market price is always positive. They may be well operating in terms of share prices, and shareholders may be very well purchasing them. It is because the market price of equities is not solely dependent on the book values of the company, it depends on the number of factors like company outlook, operating cashOperating CashCash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital. flows, the realizable value of assets, a past company record.
Negative Shareholders Equity Video
Since the net worth of the company represents its financial health, it may be a warning signal for the investor to exit the investment in case of negative net worth. However, this is not the only factor that should be considered while evaluating buy or sell decisions.