Explained: Shareholder’s equity on the balance sheet of a company
Shareholder's equity is residual claim on the company's assets belonging to the company's owners once all liabilities have been paid.
Financial statements are formal records of the financial activities and position of a business. There are four basic financial statements – balance sheet, income statement, cash flow statement, and statement of changes in equity.
Shareholder’s equity is an account on a company’s balance sheet. It consists of the company’s share capital and retained earnings.
The company has a requirement for share capital in order to finance its operations. In simple words, share capital is the amount a company raises by issuing common or preference shares to the investors. The amount of share capital a company has, changes over time with additional public offerings, or as per the requirements of a company. It usually includes common stock, preferred stock, and additional paid-in capital.
There are various types of share capital –
--Authorised share capital is the maximum amount a company is allowed to raise, which is mentioned in the company’s memorandum of association.
--Issued capital is a portion of the authorised capital, which is circulated to the general public for subscription.
--Subscribed capital is that part of issued capital, which is subscribed by the investors.
--Called-up capital is the amount of share capital that shareholders owe and are yet to be paid.
Retained earnings are the amount of profit a company is left with after paying all its direct & indirect costs, income taxes, and dividends to its shareholders. The decision to retain the earnings or distribute them among the shareholders in the form of dividends is in the hands of the company’s management. A company, which is in the expansion phase, may not pay dividends at all or pay in small amounts. Generally, the company uses this amount to expand its operations, invest in new equipment, research & development activities, and marketing, etc.
The shareholder’s equity is also represented as the residual value of assets minus liabilities.
Hence, it can be expressed as:
Shareholder’s equity = Assets – Liabilities or,
= Contributed capital+ Retained earnings.
It is important to understand the concept of shareholder equity ratio as it states the proportion of a company’s assets that are financed using shareholder's funds. It also represents the shareholder’s claim on the company’s assets at the time of winding down a company. Hence, the higher the ratio, the better it is for investors.
Shareholder equity ratio = Shareholder’s equity/total assets.