Shareholder’s EquityFinancial Statements
Shareholder’s Equity represents all of the money invested in the firm and the return on these funds over time. It also contains the firm’s net worth after all debts and liabilities are settled. This is the only other alternative for funding other than liabilities, which contain loans and credit. Shareholder’s Equity contains Common Shares, Preferred Shares, Paid-In Capital, Retained Earnings, and Treasury Shares as its categories.
Common shares are the primary source of investment funding for companies. Companies raise funds by selling these shares to investors, corporations, governments, investment funds or investment banks. In exchange they receive cash. This cash requires neither repayment nor interest, but the company’s management must work to increase the value of the shares, or face consequences such as replacement. Common Shares are partial ownership rights, and the more that is owned by an investor, the more power they have within the corporation. Owners of these shares may vote to change members of the board of directors, who in turn may change the management of the company itself. As a cost to their control, and therefore responsibility, the shareholders are the last in line to have their losses reimbursed in case of bankruptcy or liquidation.
Preferred shares are also a source of capital funding for companies. They have no direct rights in terms of voting and control over the company or its management. In exchange for the loss of power, they receive other benefits. The first benefit is first rights to dividends that are paid out by the company. The second benefit is in the event a company goes bankrupt or is liquidated, the preferred shareholders receive reimbursement after creditors but before common shareholders. Many companies wisely avoid releasing preferred shares since they require a payment of dividends to shareholders. The issue with preferred shares is that the requirement to pay dividends requires that cash earnings flow outside the company. This turns the required dividends on preferred shares into an interest that is never paid off and makes investment funds from preferred shares expensive in the long run. To top it off, dividends are not written off on taxes.
Paid-In Capital consists of the excess funds paid above par value for Common and Preferred shares. When selling common or preferred shares, the company sets a “Par Value”, which is usually a small nominal value. Every time stock is purchased directly from the firm above the par value, the excess is paid-in capital. Par value has no relationship to the market price except for when dealing with preferred stock. In the case of preferred stock, par value is used to calculate dividends.
Retained Earnings are the leftovers of net income after all adjustments have been made to net income. After all expenditures have been subtracted from Net Income, including taxes, interest charges, dividends, and share buybacks, retained earnings are any dollar amount the company gets to pocket. Retained earnings are taken from the income statement and added to the Retained Earnings on the balance sheet. Retained earnings can also increase if a company merges with another firm with a positive retained earnings pool. Retained earnings steadily accumulate over time if the firm is profitable. If the suffers a loss, retained earnings decreases. If the firm ever hits negative retained earnings, the possibility of bankruptcy is fairly high. You should seek companies that have consistent growth in retained earnings. Retained earnings are the only source of growth that does not dilute shareholder’s potential profits. Loans require interest payments, common shares dilute investor’s holdings, and preferred shares require dividends paid from the firm’s revenue. Companies that rely on those methods to fund expansion actually hamper themselves over the long term. Firm growth is best fueled by retained earnings.
Treasury shares are shares that firms have removed from the market by purchasing them and storing them in treasury. This is one of two options for shares that are purchased via a buyback, the other of which is permanent deletion. Shares that are stored in the company treasury neither receive dividends nor have voting rights, since the company owns them. Since the company owns all treasury shares, they are not owned by shareholders directly. Due to this they are listed as inverse to shareholder wealth and are subtracted from shareholder’s equity. There is one upside to this slightly confusing statistic: The purchase of treasury shares reduces the amount of common shares on the market and increases the value of the other shares since they count against shareholder’s equity and have neither dividend stipends nor voting rights. You should actively seek out companies that normally convert common shares to treasury shares without excessively spending. Firms that can commonly and regularly do this are silently increasing the wealth of its investors over the long term simply by reducing the shares outstanding. However, you should also beware that increasing treasury shares distort ratios like return on equity, and should look to see whether or not firms are improving ratios based on return, or inflating through buyback programs.
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