Companies have to prepare financial statements that indicate the sources of income and expenses and company’s financial position at a given point in time. The latter information is captured in the Balance Sheet, which has three main components – Assets (what the company owns), Liabilities (what the company owes), and Equity (Assets – Liabilities). Amongst all this, then what does negative equity mean?
Crux of the Matter
What Is Equity?
Equity is the amount shareholders would receive if a company sold all its assets and repaid all its liabilities. A business prepares a financial statement called the Balance Sheet, which has three main components: Assets, Liabilities, and Equity.
Mathematically, Liabilities + Equity = Assets. Thus, Equity = Assets (what a company owns) – Liabilities (what a company owes).
What Is Negative Equity?
When liabilities exceed assets in a business at any point in time, then the shareholders’ equity would be negative. Mathematically, Assets – Liabilities < 0.
1. Accumulated Losses
The profit or loss in a given period is added to the Equity portion of the Balance Sheet. Negative shareholders’ equity occurs when the losses exceed the equity amount, that includes previous earnings, amount received from new stock issue, etc.
2. Large Dividend Payments
Large dividend payments that exhaust the retained earnings and exceed the shareholders’ equity can result in negative equity. Dividend payments announced when losses have accumulated (as seen in the previous slide) also result in the same.
3. Borrowing More Money
To cover accumulated losses, a company can:
a) Issue more stocks – this results in positive equity.
b) Raise money through debt – there is cash inflow, but the equity remains negative.
Amortization is the depreciation of intangible assets. It is recorded under Equity. If amortization expenses exceed the retained earnings and shareholders’ equity, then it will result in negative shareholder equity.
For all stakeholders of the business, negative shareholders’ equity is a sight of caution that the business isn’t performing well, with some countries even requiring companies to mandatorily raise additional equity in such a case.
However, the share price of a company is determined by the market forces and is always positive or zero.
- In many countries, assets with negative equity are often referred to as being “underwater“. While loans and borrowers with negative equity are said to be “upside down“.
- A credit crunch is a sudden reduction in the general availability of loans (or credit) or a sudden tightening of the conditions required to obtain a loan from banks. A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates.
- McDonald’s owns the majority of land on which its restaurants are situated, which is valued at an estimated $16 to $18 billion. The company earns a significant portion of its revenue from rental payments from franchisees. In recent times, there have been calls to spin off the company’s U.S. holdings into a potential real estate investment trust, but the company announced at its investor conference on November 10, 2015, that this would not happen.