Negative Shareholders Equity | Examples | Buyback | Losses

Have a look at Colgate’s Shareholders Equity. Its Shareholders’ Equity is Negative.

Is Negative Shareholder’ equity a danger sign, implying investors to stay away from this stock? Negative Shareholder’ equity is, in most cases, due to losses accumulated over the years by the company.

In this article, we look at negative shareholder’s equity in detail –

Let us first go back to the basic accounting equation. Shareholder’s equity is simply the difference between Assets and Liabilities.

In other words, the amount of capital the proprietor brings in when the business is started. In the case of a company, it is the amount of capital the shareholders subscribe to.

As shown above, equity is the portion of the difference between the assets and liabilities. It also includes reserves that are accumulated over some time through profits.

If you are new to accounting, you may use this finance for non-finance books.

On the other hand, Negative equity refers to the negative balance of equity share capital in the balance sheet. This situation usually happens when the company has incurred losses over a continuous period such that they offset the reserves and equity capital appearing on the balance sheet.

It can happen because of a number of other reasons too. However, the following are the major reasons for negative equity.

• The company is over-leveraged, which means that there is a huge amount of debt. When a company incurs losses, this results in cash outflow. So, the company generally borrows to stay and operate. This circle goes on, which generally results in a huge pile-up of debt, and the company is incurring losses. Additionally, once a company enters this phase of negative equity, it decreases credit ratings, further resulting in higher interest rates.
• Treasury Stock Repurchase - The company may buy its common stocks as per the company’s stock repurchase plan. It results in the reduction of equity. If large amounts of common stock are repurchased, it can lead to negative shareholder equity.
• Dividend Payments - If the company has paid more cash dividends than the profits it earned, it can result in negative shareholder’s equity.
• Creation of Provisions - Negative shareholder’s equity can also happen when the company has created large provisions for the future expected Financial Liabilities.

Also, note that negative retained earnings do not necessarily mean that the shareholders have to give money to the company. Under the company laws, shareholders are liable only to the extent of the money they invested in the business.

In the case of negative equity companies, if they liquidate or dissolve, shareholders probably receive nothing in exchange for their initial investment. However, if the company realized more by selling its assets, it may pay shareholders even though there is negative equity.

Let me explain this concept to you with the help of an example.

Mr.X wants to start the business of steel coils. He bought $1,00,000 from the bank as a loan and $50,000 as his contribution. Now he purchased assets for establishing the business US$ 25,000 for buying a building and godown and $5,000 for furniture, US$ 60,000 for purchasing steel stocks (inventory). Rest US$ is in Cash. Now, all set, so he went to start the business. His opening balance sheet appears as follows.

So, he eventually started the business, started selling steel. Due to the difficult business environment, the steel prices started to fall, and he could sell his inventory of $60,000 at $35,000, incurring a $25,000.

Additionally, he took an additional loan of $40,000 and bought a stock of $80,000.

Cash Balance = $60,000 (opening) + $35,000 (sale of steel inventory) – $80,000 (new stock) = $55,000

The closing balance sheet is as follows.

In the above case, Assets- Liabilities is 1,65,000-1,40,000 which is US$ 25,000 whereas Shareholders Equity is 25,000

Now let's move on.

In the next year 2017, the prices fell further. The stock of US$ 60,000 is sold for only US$ 25,000, at a loss of US$ 35,000.

Reserves and Surplus = -$25000 – $35000 = -$60000

Total assets, in this case, is US$ 1,30,000, whereas liabilities are US$ 1,40,000, making shareholders equity negative.

See the following balance sheet of American Multinational cosmetics company, Revlon incorporation 2013.

source: Revlon SEC Filings

As you see in the above snapshot, there is a huge amount of negative retained earnings (accumulated deficit) in the Revlon balance sheet, leading to negative total equity. The negative retained earnings are mainly because of consistent losses from its operations, especially the slowdown in its Chinese market.

Revlon's total assets were US$3023 mn, whereas its liabilities were around US$ 3,638 mn resulting in Shareholder’s equity deficit of US$ 614.8 mn.

Let us now look at Colgate’s Shareholder’s Equity section. First, please note that Colgate is a profitable company with retained earnings of $19.9 billion in 2016.

Yet, its shareholder’s equity is negative due to two reasons –

1. Treasury Stock - As per its share repurchase plan, Colgate buybacks its shares each year. We note that Colgate has bought $19.13 bn of common stock until 2016.
2. Accumulated other comprehensive income - This is another reason Colgate’s shareholder’s equity is negative. Each year, other comprehensive losses increase the losses even further. (For details, look at Accumulated other comprehensive income)

Consolidated Statement of Changes in Shareholder’s equity provides us with comprehensive details of the Shareholders Equity section. Please see below Colgate’s Consolidated Statement of Changes in Equity.

In 2016, Colgate repurchased $1.55 billion worth of common stocks. Also, other comprehensive losses net of taxes was -$230 million in 2016.

source: Colgate SEC Filings

Let us now have a look at the shareholder’s equity section of HP. First, we note that in 2015, HP’s shareholder’s equity was $27.76 billion; in 2016, it turned negative to -$3.88 billion. Why?

source: HP 10K filings

The primary reason HP’s Shareholder’s Equity went negative was changes in Retained Earnings. Please note that HP’s changes in retained earnings were not because of losses as HP. HP is profitable and reported Net earnings of $2.49 billion in 2016.

HP’s Shareholder’s Equity turned negative due to its Separation of HP Enterprise that led to the reduction of shareholder’s equity of -$37.2 billion. Additionally, negative shareholders’ equity was further compounded by the cash dividends of $858 million.

• Increased interest rates by banks
• Difficulty in getting further funds either through loans or equity
• Reduction in credit period offered by creditors, or they may deny credit sales.
• Decrease in corporate valuations and credit ratings
• Decrease in orders as the customers fear for the company honoring the contract
• Unable to pay dividends to shareholders
• Fall in company stock price
• Company may be classified as per laws as a sick company
• May result in employee layoffs, which may result in the degradation of company name & fame and employee morale.

Just because the equity in the company books is negative, that doesn’t mean that the company share price in the market is zero or available for free. On the contrary, the market price is always positive. This is because they may be well operating in share prices, and shareholders may be purchasing them very well. It is because the market price of equities is not solely dependent on the book values of the company, it depends on the number of factors like company outlook, operating cash flows, the realizable value of assets, and a past company record.

Since the company's net worth represents its financial health, it may be a warning signal for the investor to exit the investment in case of negative net worth. However, this is not the only factor that should be considered while evaluating buy or sell decisions.

• Operating Cash Flow Calculator
• Shareholders Equity Statement
• What is Share Buyback?