Stockholder Equity on the Balance Sheet
Shareholder equity represents a stockholder's claim to the assets of a business after all creditors, liabilities, and debts have been paid. In layman's terms, it represents net worth. Shareholder equity is also referred to as owner equity or stockholder equity.
When used in conjunction with figures from the company's income statement, shareholder equity can help illuminate the quality of a firm's economic engine and provides insights into its capital structure.
How Shareholder Equity Appears on the Balance Sheet
When looking at a balance sheet, shareholder equity usually comes from two sources:
Shareholder equity is adjusted for a number of items. For example, the balance sheet has a section called "Other Comprehensive Income," which includes things like valuation allowances for changes in the market value of certain securities or investments held in certain classified ways as well as cumulative translation allowances on foreign currency as it pertains to assets and liabilities.
There's no substitute for diving into the annual report and Form 10-K filing to read the disclosures and explanations. This lets you piece together an understanding of how accounting reflects the economic reality of the company's condition.
When More Is Better
If investing in bank stocks, for example, more shareholder equity is ideal. Although it may lower return on equity, it means a bigger margin of safety in the event losses develop in the loan book. There's more equity to absorb bad debts that aren't repaid—either due to poor underwriting or a general economic recession or depression.
When Less Is Better
For many businesses, the less the shareholder equity, the better. In some cases, shareholder equity doesn't have much meaning at all because it doesn't take much money to produce each dollar of surplus-free cash flow, so the enterprise can scale and throw off wealth for owners much more easily.
Think of the maker of a popular phone or tablet game—a team of young developers who set up a limited liability company and work from their home.
Once the initial software is created—little of which required shareholder equity as it was mostly bootstrapped from the founders and developers putting in their time—it doesn't take any net worth to produce income.
The game is on the various platforms where players can buy it or process transactions for in-game purchases and nearly all the revenue is unrestricted free cash flow if the business is well-run and structured correctly.
If it becomes a hit, it'd be possible for millions of dollars in income to be produced from practically no shareholder equity at all. It's very different from something like a railroad, which requires huge expenditures on rail track, rail cars, and the maintenance of such equipment and infrastructure.