Yesterday, we talked about liabilities being what your company owes. We also touched on ratios and how they can be helpful in getting useful data out of your financial statements.
Today is the last section of the balance sheet, called Shareholders’ Equity.
Equity is the amount left over when you subtract liabilities from assets—it’s the residual claim that shareholders would have to the assets if they were liquified and the debts were paid. Think of it as the piece of your house you actually own versus the piece the bank owns. As you pay the mortgage, you slowly own more and more, and the bank owns less and less. The difference between what your house is worth (the asset) and what you owe the bank (the liability) is the equity you have in your house.
Shareholders’ equity is made up of the amount paid to the company for shares (share capital) plus the net income (or minus the net losses) from inception. This is called retained earnings, minus any dividends paid out.
Dividends are a disbursement of the retained earnings of a company to its shareholders. Let’s say that the company has been in business for two years, and both years, there was a profit of $10k. At the beginning of the third year, there’s $20k in retained earnings, and the company’s management decides to give some of that back to shareholders. Management would declare a dividend of a certain amount per share and would pay out the cash owed to each shareholder based on the number of shares they held.
Dividends can only be paid out to the extent that there are retained earnings to disburse. So, in our $20k example, a maximum of $20k in dividends could be paid out.
For small, private companies (not traded on a stock exchange), this is a way for the shareholder(s) to withdraw cash from the company to pay themselves. Dividends have been used traditionally because they’re paid out of after-tax income from the corporation’s perspective (i.e., the corporation has already paid tax on that income) and are usually taxed at a lower rate on the personal level. So overall, if you added up the tax paid by the corporation and the tax paid by the individual, it would be lower than if the individual had taken a salary, paid tax on that type of income, and the corporation was able to deduct the salary for tax purposes. I recommend checking with the tax laws in your country before declaring dividends for yourself.
As with the income statement and the other two pieces of the balance sheet (assets and liabilities), comparing equity to other numbers is where the meaning is derived. Looking at the relationship between debt and equity (total liabilities / total equity) tells you the proportion of assets financed versus owned outright. If this ratio is too high, the company is said to be highly leveraged and is a greater risk to lenders, which means higher interest rates and a reduced opportunity for financing.
The ratio shouldn’t be too low either because it means you’ve probably missed a growth opportunity. If you finance everything with your own money, the growth of the company will be much slower than if you borrow money to grow. This ties back to what we were talking about yesterday. If you can make more with borrowed money than it costs to borrow it, you’re better off borrowing it.
Shareholders’ equity illustrates the number of assets owned by the shareholders and not by a debtor. It’s the accumulation of income over the course of the company’s life and describes the amount that could be paid out in dividends, which is important to anyone looking to invest. It can also be compared to other pieces of the balance sheet to get useful information that otherwise wouldn’t be available.
Task: Use the ratios we learned today on the balance sheet from two days ago. What can you learn from your balance sheet that you didn’t know before?
Tomorrow, we’ll be wrapping up the course and summarizing what we’ve learned.
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