Negative Shareholders’ Equity: 5 Reasons You Should Know

A company has no legal obligation to return Shareholders’ initial paid-in or contributed capital. Contributed capital comprising paid-in capital and share premium is utilized to fund business operations. When a business performs well and generates profits its equity rises.

However, several factors cause the Shareholders’ equity to go in the negative column. As the total Shareholders’ equity comprises different components, either component alone or a combined effect of all can result in negative equity.

Let’s understand Shareholders’ equity components and the calculation for net Equity.

Shareholders’ Equity = Total Assets – Total Liabilities

In simpler terms, if total liabilities like long-term debts outweigh the total assets, shareholders’ equity will be negative. A highly leveraged company that has borrowed more than its underlying assets, represents negative equity.

Another reason can be the cost of debt may rise significantly due to a change in the interest rate. There are several factors in liabilities that can yield negative total equity.

1) Negative Equity Due to Excessive Debt Financing:

A company looking for cash needs can borrow money through debt financing. Excessive borrowings or net losses arising through financing activities can make liabilities outweigh the assets.

A highly leveraged company can represent negative equity on its balance sheet as equity is valued at book values.

High borrowings are a common reason for large companies showing negative total Equity. The main factor behind the costly debt financing is unsecured loans and high-interest rates.

Once a company’s leverage ratio is higher than normal, its borrowing abilities shrink and lenders charge even higher interest rates.

2) Negative Equity Due to low Retained Earnings:

Retained Earnings represent a significant portion of total equity. A company may decide to fund a project with retained earnings or pay a large dividend to its shareholders. Specifically, the dividend decision can affect retained earnings.

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As the company may announce dividends in advance and at a pay-out date the total value of retained earnings or cash surplus may not be large enough.

A company performing badly for consecutive years accumulates net losses in retained earnings as a negative balance. A significant amount of negative retained earnings or losses can outweigh the assets and show negative equity as well.

3) Negative Equity Due to Share Buyback:

Large companies with multiple IPOs may have a substantial figure of outstanding shares in the market. A Large number of shares affect the EPS, DPS, and P/E ratios that are vital in company net worth evaluations. A company can buy back shares through treasury stocks or a share repurchase.

These shares are accounted for in a separate accounting entry under the total Equity section. A large buyback transaction can also result in negative total equity for shareholders.

A real-world example of a large treasury stock amount and negative shareholders’ equity is McDonald’s incorporation.

Although the company has reported significant profits of $6,025 million and a large EPS of $ 7.88, still it reports negative equity of ($ 8,210) million. The negative equity is mainly due to a large treasury stock accumulation of ($ 66,238) million. Data Source:

4) Negative Equity due to Negative Asset Valuations:

By definition, even if the assets are valued at zero value the liabilities will results in negative net equity for shareholders. That scenario represents in an insolvent or bankrupt situation. Another possible scenario can be the negative Goodwill or a large intangible asset’s amortization value.

Both Goodwill and intangible assets make up for a significant total asset’s portion of modern tech-based giant firms like Facebook and Google. Any market risk or a large transaction in amortization brought under the retained earnings (or other reserves) can also result in negative equity.

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5) Consolidated Negative Shareholder’s Equity:

Mergers and Acquisitions happen mainly to gain the advantage of synergy effects. Some companies also acquire another for access to valuable assets such as cash, patents, and intangible assets like software.

However, many mergers fail due to the overvaluation of intangible assets and goodwill. Some companies may also offer a considerable overvalued share price offer to secure the deal. Any resulting negative Goodwill or carried over accumulated losses can result in total negative equity for consolidated statements.

Key Points on Negative Shareholder’s Equity:

Shareholders’ total equity comprises of several components like contributed capital, share premium, retained earnings, and Reserves. Negative equity does not imply that a company is unsuccessful.

A thorough investigation into the reasons for negative equity can reveal the true financial position for the Shareholders.

A large borrowing or excessively leverages firm may represent default risk. However, lower retained earnings can be due to a one-off transaction of dividends or any other investment.

Similarly, the large negative treasury stocks can be reissued to the shareholders at any time and do not reflect any negative consequences for shareholders.