The statement of stockholders equity is a pivotal part of a company’s balance sheet. It’s a financial document that showcases the changes in shareholders’ ownership in the company over a particular accounting period. 

In this article, we elaborate on the importance of the statement of stockholders equity, its components, and how easy it is to calculate.

Components of Stockholders Equity

There are 6 primary components to the statement of stockholders equity:

Preferred Stock

As the name suggests, the owners of these stocks (or shares) have a preferential right to the company’s earnings and capital (at the time of winding up). At the time of dividend distribution, the preferred stockholders are the first ones in line. Preferred shares are shown at their list (or par) value in the financial statements of the business.

Common Stock

The other type of stock is common stock. The ownership of common stock will get the buyer a share in the share capital of the company. It entitles the holder to vote on any business decisions or policies. 

However, dividends are paid to common stockholders upon payment to the holders of preferred stock. If the company goes into liquidation, the common shareholders will obtain what remains after satisfying the claims of preference shareholders and bondholders (or other obligations). 

They are also disclosed at nominal value in the financial statements. Both preferred and common stock are equity accounts that form the share capital of the company.

Treasury Stock

A company often repurchases its own shares in an attempt to reduce the total number of shares outstanding in the market. Such reacquired shares are known as treasury shares or treasury stock. 

This is a contra equity account, which means that it reduces the stockholders’ equity. These shares are not included in the calculation of the company’s EPS (earning per share), and do not carry any divided rights. These can be stated at cost or list value in the financial statements.

Additional Paid-up Capital

The list price of a share is often different from what an investor actually pays to the company for buying that share. The difference between these two prices is known as the additional paid-up capital. 

Retained Earnings

Retained or ploughed back earnings is defined as the money earned from business activities but not distributed to the shareholders. It is calculated as the difference between the total income of the company and the dividends issued to the shareholders. 

Retained earnings are primarily used for the growth and expansion of the company’s business.

Unrealized Gains and Losses

These refer to the fluctuations in the pricing of investments of the company. An investment that has increased in value but has not yet been realized (or cashed) is an unrealized gain for the corporation. Similarly, an investment whose value plunges but the sale has not been initiated forms unrealized losses.

The values at the start and at the end of the accounting period of all 6 of these balance sheet items are presented in the statement of shareholders (or stockholders) equity.

Importance of the Statement of Stockholders Equity

The statement of shareholders equity forms an indispensable part of a company’s financial statements. It is a reflection of the company’s performance and fiscal health. It aids the company to rationalize its financial decisions and the investors to decide whether to invest in the company.

Importance #1: Financial Decisions

A company is able to correctly evaluate how much profit it should keep and how much it should distribute to its shareholders with the help of this statement. It also keeps the expenses of the business in check. 

Negative or declining retained earnings will incentivize the company to reduce its dividend payment or raise more money through additional issuance of shares or borrowing.

Importance #2: Calculation of Ratios

The statement is used to compute various financial ratios, such as:

Debt-to-equity ratio: Higher retained earnings will substantially increase the equity (business owner’s claim in the business) and therefore reduce this ratio, making the business of the company more trustworthy and capable of raising a loan.

Return-on-equity ratio: This ratio tells the investors how much income a company can generate as a percentage of stockholders’ equity and is, therefore, an important determinant of the operational efficacy of a company.

Importance #3: Determinant of Investment Decisions

The statement of stockholders equity is an important document for potential investors who will put their foot down and invest in the company only on the back of a healthy shareholders equity. 

This is because higher shareholders equity means greater long-term stability that, in turn, will provide investors the desired appreciation of their investments. On the other hand, a negative shareholders equity means that the company’s assets are not enough to pay off its liabilities. 

This hints at a possible liquidation or bankruptcy in the near future, and such companies are considered a risky investment by external investors.

How is a Statement of Stockholders Equity Prepared?

Prior to arriving at the true statement of equity, the following 3 things should be mentioned at the top of the statement:

• Name of the company

• Title of the statement

• Accounting period of the statement

Step #1: Begin with the opening equity balance, which is the shareholders’ equity on the first day of the accounting period.

Step #2: Add any investors’ investments during the concerned period of time.

Step #3: Subtract the dividends paid to the shareholders. Any purchase of treasury stock should also be deducted from the statement.

You now come to the shareholders’ equity figure at the end of the accounting period. 

Alternatively, shareholders’ equity can be calculated by subtracting the total liabilities of the corporation from its total assets, both of which are mentioned in the balance sheet.

That’s because under the original accounting equation,

Equity + Liabilities = Assets

Total liabilities represent the sum of current and non-current liabilities. Current liabilities are obligations that are due or will become payable in the next 12 months. Non-current liabilities, such as money raised from long-term loans, are generally due beyond 12 months.

Total assets are the aggregate of current and noncurrent assets. Current assets are those assets that are expected to be converted to cash over the course of a year. Noncurrent assets or long-term assets such as buildings, machinery, etc. are assets that a company plans to use for more than a year.

While a statement of stockholders equity is an important document to properly create, it’s not as complex as it may seem on the surface. We hope this guide better helped you understand how to create one in your business.