Updated July 15, 2023
Definition of Negative Shareholder Equity
Negative shareholders equity arises in the company when the total liabilities of the company exceeds the value of total assets of the company due to certain factors like large dividend payment, large borrowings including short term debts and long term debts (along with leveraged loans), a large amount of accumulated losses, etc., as because of this, the balance in shareholders’ equity account at a particular point of time becomes negative.
The basic accounting equation is Assets = Liabilities + Shareholder’s Equity.
Alternatively, we can say that Shareholder’s equity = Assets-Liabilities, i.e., the portion of the difference between assets and liabilities refers to equity. This equity portion also includes the accumulated profit over a number of years in the form of reserves. When the company has continuously incurred losses over the past years, it has to use the balance in its reserves and equity capital accounts to offset such losses. Hence, it results in negative share capital in the company’s balance sheet.
Example of Negative Share Capital
Let us consider company XYZ ltd which is going to set up newly. The company XYZ Ltd borrows $60,000 from the bank as a loan, and his contribution to the company is $90,000.The company also purchased various assets in the form of building and godown, valuing $30,000, furniture worth $6,000, inventory for $70,000, and a balance figure of $45,000 in the form of cash. The Company started the business. The opening balance sheet of XYZ Ltd was good enough. After the end of the first year, XYZ Ltd incurred a loss of $ 30,000 as the value of its inventory fell to $40,000, which was sold in full. To increase the value of its stock, the company purchased a stock valued at $90,000 by taking an additional loan from the bank valuing $60,000.
In the next year also, the company incurred losses of $75,000 as it sold stock worth $90,000 for $15,000. Calculate the value of equity of the company during the year.
After making all the calculations during year end, the reserves and surplus of the company went into a negative balance
Reserve and surplus at the end of year 1 = Loss during the year = $30,000
Value of equity at the end of Year 1
|Loss during the first year (Reserve and surplus balance)||($30,000)|
|Equity Balance at the End of Year 1||$60,000|
2nd Year-end calculations
The total loss and the balance in reserves and surplus at next year’s end will be: Loss of the previous period + loss of the current year
- Reserve and surplus balance = $30,000 + $75,000
- Reserve and surplus balance = $105,000
Value of equity at the end of year 2
|Equity Balance at the Year 2||$90,000|
|Total accumulated Loss at the end of year 2 (Reserve and surplus balance)||($105,000)|
|Equity Balance at the End of Year 2||($15,000)|
Hence, there is a negative balance of equity at the end of year 2, amounting to $15,000
Causes of Negative Shareholder Equity
The following is the reason for the negative shareholder equity
- Overpayment of Dividends: When the company has paid the dividend in the form of cash exceeding the profits it has earned during the year, it results in negative shareholder equity.
- Large provisions created: with the expectation of meeting large financial liabilities in the future, the company creates the provisions. If any provisions are created in the current period, it results in negative shareholder equity.
- Repurchase of Treasury stock: Sometimes, the company purchases its common stock as per its stock repurchase plan. Equity gets reduced due to the repurchase of the company’s stock. If the number of repurchased stock increases, it results in negative shareholders’ equity.
- OverleveragedCompany: When the company makes huge losses, it results in high cash outflow. Also, if it has taken a huge amount of debt, it results in huge debts. In such a situation, borrowing helps the company in its survival. If this cycle continues for a long period of time, a huge amount of debt gets piled up on the company. Also, the interest rate of borrowing keeps increasing the company’s cost. Hence, eventually, the company goes to negative shareholder equity.
- Amortization of intangibles: In the acquisition process, the company often amortizes its intangible assets recorded as part of the acquisition. If the amount of amortization is large, it results in negative shareholder equity.
Following are the benefits of negative shareholder’s equity
- With the help of negative shareholder equity, the shareholders or the investors get the idea of the deterioration of the company’s financial health.
- Negative shareholder equity alerts the shareholder or investor to make any new investment in the company further or just run away at the present time, providing warning signals.
- Negative shareholder equity is far better than the insolvency of the company. It allows the investor or shareholder to make themselves safe because if the company cannot improve its negative shareholder equity, it can go for insolvency, which is the last step. The shareholder and investors can’t save themselves from the losses of insolvency.
Important Points of Negative Shareholder Equity
The following are some of the important points about negative shareholder equity:
- Suppose negative shareholder equity occurs for a long time. In that case, the company may come to a situation where it will be unable to pay the dividends to the shareholders, hence losing the existing shareholders.
- Also, the company will face many difficulties acquiring new loans and debts.
- As negative shareholder equity creates fear in shareholder’s or investors’ minds, the company also loses many of its potential customers and investors in the future.
- The stock price of the company’s shares considerably falls, eventually resulting in an even worse situation for the company’s survival.
- However, many other factors can affect the company’s financial health and negative shareholder equity, which should be considered while making investment decisions by the shareholder or investor.
The company’s negative shareholder can be a warning signal for the shareholder or investor because its net worth represents its financial health. However, the shareholder or investor should consider other numbers of factors also in consideration while making the decision to purchase shares or investment in the company.
This is a guide to Negative Shareholder Equity. Here we also discuss the definition and examples of negative shareholder equity, benefits, and importance. You may also have a look at the following articles to learn more –