Stockholder’s Equity: Basics and Ways to Increase It
What is equity?
Equity, also called owner’s or stockholder’s equity, is the foundation and financial basis of the company. Equity is the amount of funds, the source of which is its owners (shareholders, stockholders, and so on). Thus, stockholder’s equity both complements and opposes borrowed capital, which is all the funds of the organization the source of which are creditors.
In the Balance sheet, this difference is expressed as follows: a separate section of the Balance sheet with the same name is allocated for equity capital, while borrowed capital is reflected as part of the company’s short-term and long-term liabilities. At the same time, stockholder’s equity, in essence, is also an obligation of the company, only to the owners of the stocks.
In the Balance sheet report, equity is presented in a separate section, and, actually, it is the difference between all the assets of the enterprise and its liabilities. Equity capital can increase or decrease depending on additional financial or property investments and the results of the enterprise’s activities.
The main functions of the stockholder’s equity include:
- Protective. Equity allows maintaining the company’s solvency;
- Operational. Ability to direct own funds to purchase the necessary assets;
- Distributional. Ability to distribute profits in the form of a withdrawal or dividends).
What does equity consist of?
Equity represents the business’s own sources, which were contributed by the founders and stockholders as contributions or accumulated in the form of retained earnings. An organization’s equity consists of several components.
The maximum stock size a company can put up for sale at one time is determined by the charter and constituent documents and is known as the authorized capital. For companies of certain organizational and legal forms, the minimum amount of the authorized capital is regulated at the legislative level. It can issue common stocks, which is more typical, or also offer preferred, which are simply VIP-level stocks that cost more and have their special perks, such as being the first to receive the dividend payments. You might also come across treasury stock, which is simply the stock the company issued but later decided to buy back for various reasons.
Additional paid-in capital represents the share premium of the entity, which is secured by the difference between the sale and the par value of the shares. The source of additional paid-in capital may be the sale of part of the firm’s assets at a price that exceeds their book value. The unpaid capital is considered to be the part of the capital not yet paid up by the entities who purchase the shares. Other additional capital is the amount of revaluation of non-current assets, the price of assets that the company received free of charge from other entities.
Reserve funds are part of the equity capital that is intended for internal insurance of its activities. The size of the reserve capital is determined by the constituent documents, and its formation is carried out at the expense of deductions from the profit of the enterprise. Retained earnings act as a kind of reserve and are a part of the company’s profits received in the previous period(s) and not used by the business or owners in the form of dividends or withdrawings. These funds are intended for reinvestment in the development of the business. However, that is not the only purpose they serve. Retained earnings can be used by an enterprise, depending on its organizational and legal form, in the following ways:
- formation of reserve capital;
- payment of dividends, distribution of net profit;
- increase the authorized capital;
- to cover previous accumulated losses.
How to increase stockholder’s equity?
The size and dynamics of stockholder’s equity is the most important characteristic of the state of the company, its reliability. Among the parameters that determine the position of the company in the market and its position relative to competitors, the value of stockholder’s equity is mentioned along with the profit and other financial indicators.
There are several ways to increase the equity of a business. Of course, it can go out and sell more shares if it has not sold the maximum amount yet. It can also better promote its business and take other necessary measures to increase the value of the company on the market.
As you saw above, another component of the equity of the business is the retained earnings. To increase this particular item, the company can choose to hold on to more of the net income or not distribute any of it for some time. The best option, though, would be finding ways to increase profits and minimize expenses and costs so more income can go towards Retained earnings. Which option is the best possible way to go depends on the specifics of your particular business. Obviously, there is no easy way to go about it, but there might be a more rational and effective strategy to achieve your goal.