Stockholders' equity is the amount of capital given to a business by its shareholders, plus donated capital and earnings generated by the operation of the business, less any dividends issued. On the balance sheet, stockholders' equity is calculated as:
Total assets - Total liabilities = Stockholders' equity
An alternative calculation of stockholders' equity is:
Share capital + Retained earnings - Treasury stock = Stockholders' equity
Both calculations result in the same amount of stockholders' equity.
The stockholders' equity concept is important for judging the amount of funds retained within a business. A negative stockholders' equity balance, especially when combined with a large debt liability, is a strong indicator of impending bankruptcy.
A number of accounts comprise stockholders' equity, which typically include the following:
- Common stock. This is the par value of common stock, which is usually $1 or less per share. In some states, par value may not be required at all.
- Additional paid-in capital. This is the additional amount that shareholders paid for their shares, in excess of par value. The balance in this account usually substantially exceeds the amount in the common stock account.
- Retained earnings. This is the cumulative amount of profits and losses generated by the business, less any distributions to shareholders.
- Treasury stock. This account contains the amount paid to buy back shares from investors. The account balance is negative, and therefore offsets the other stockholders' equity account balances.
Stockholders' equity can be referred to as the book value of a business, since it theoretically represents the residual value of the entity if all liabilities were to be paid for with existing assets. However, since the market value and carrying amount of assets and liabilities do not always match, the concept of book value does not hold up well in practice.