Shareholder’s Equity (SE) is a financial metric used by analysts to determine the health of a company. Accountants estimate the value of the company if it liquidated and paid debts today using this measure. Also, let’s take a look at how investors and analysts use this metric.
What Does Shareholder’s Equity Mean
What is the calculation for SE? Simply, it is SE = Total Assets – Total Liabilities. Furthermore,the definition is intuitive in the sense that it shows the amount shareholders expect in the event of a liquidation. Investors concern themselves with risk, and SE helps detail the worst case scenario.
Additionally, this metric measures bankruptcy risk. If a company has more liabilities than its current assets, solvency risks may arise in the near future. Negative Shareholder’s Equity companies pose greater bankruptcy risk than those with positive.
Shareholder’s Equity Example
Also, let’s take a simple example explaining this measure. Suppose you invest $10,000 in a business, and borrow another $10,000. You now have $20,000 in assets. However, you owe $10,000, which is a liability. Therefore, you own $10,000, which is shareholder’s equity.
Additionally, in what ways does SE grow? If a business makes a profitable sale, assets grow. If management retains that profit in the business, it adds to SE. Conversely, if management takes that profit out, SE stays the same. Retaining profits is the fastest way management grows shareholder’s equity.
Analysts refer to SE as the “book value” of the firm. For some businesses understanding the book value is paramount before making investment decisions. For others, it is basically meaningless. The determination has everything to do with sector and business models. Becoming familiar with industry practices of the interested company is necessary when analyzing any company. The balance sheet reveals much important information regarding SE.
Shareholder’s Equity is an important accounting measure to understand. Investors need it when understanding the solvency of company, and if their investment is warranted. Understanding which industries rely on this metric and which do not gives investors and analysts an advantage when analyzing companies.