How to Read a Balance Sheet – Equity Section (Simple Format)
The equity section of the balance sheet equals assets minus liabilities. Traditionally the equity section is referred to as the net worth of the company. If you were to dispose of all the assets through a sale and pay off liabilities, the money left over would be available for distribution to the shareholders. The shareholders basically own the equity section of the balance sheet.
How is this section formatted? How do you read this section? How do you determine the value of a company by reading the equity section of the balance sheet?
Before continuing, please read: How to Read a Balance Sheet.
The equity section is composed of two significant areas or elements to determine value. The first or primary area is the stock available and sold. The second area relates to the activities of the company over a period of time, this is known as retained earnings.
Stock
When a single individual or a group of individuals get together to start a company, they generally agree on a stock based company. The first step is to authorize shares of stock to be sold. Your beginning owner or novice owners say, ‘Hey, let’s allow a zillion shares to be sold!’ This sounds great because you automatically think that folks will just come running to buy stock once they find out about your great and wonderful business. However, your local State Corporation Commission has their regulations. In general, they charge more for the annual fee for the number of shares authorized to be sold. Typically they break the fees in tiers. Up to 100,000 shares, X dollars for the annual fee, from 100,000 to one million, 3X the fee, and over a million 10X the fee. For any new business operation, there really is no need to go beyond your state’s first tier of stock authorization. After all, if there is a run on your stock (unlikely) then you can seek and receive permission to sell more from the state corporation commission. Remember, the State Corporation Commission is really only interested in your money.
For the purposes of starting out, it is really best to go with the lowest tier and pay the least fee to get the corporation organized.
The stock certificate is listed at a ‘PAR VALUE’ which means some arbitrary number of price. This is generally the minimum value of worth on Day 1 of the company’s existence. For most companies, they choose $1 or $10 as the par value. However, the organizers traditionally pay much more for the stock than the par value. The dollars that are paid for the stock that exceed the par value is referred to as ‘Capital Paid in Excess’. If you started a company today and you authorized 50,000 shares for $1 par value and you sold 10,000 shares for $100,000 then your balance sheet equity section will look like this:
XYZ, Inc.
Day One of Existence (DATE)
Equity Section
Common Stock
Par Value – 50,000 Shares Authorized, 10,000 Sold/$1 Par Value $10,000
Capital Paid in Excess – (10,000 shares sold) 90,000
Total Common Stock $100,000
From the above, you can see that 10,000 shares were sold leaving 40,000 shares still available. If the board or the owners of the stock decide to sell more in the future, they can sell the stock for any price they desire. Most believe that they will sell the stock for more than the original $10 each as illustrated above. But in most situations, the company general performs at a lower than expected return forcing the current owners to give up some control of the company for some cash infusion. Assume that on Day 3, the company needs $25,000 for a new truck. An investor or buyer of stock agrees to buy stock from the company for $25,000 in exchange for 3,000 shares. This means two things. First, the company will now have sold 13,000 shares of the 50,000 allowed, and secondly, this investor is paying $8.33 per share for the stock while the Day 1 purchasers paid $10 a share. The new investor is getting a much better deal, or in business terms, his risk is reduced from the perspective of the share cost in exchange for quick cash.
Now the equity section will look like this:
XYZ, Inc.
Day Three of Existence (DATE)
Equity Section
Common Stock
Par Value – 50,000 Shares Authorized, 13,000 Sold/$1 Par Value $13,000
Capital Paid in Excess – (13,000 shares sold) 112,000
Total Common Stock $125,000
Note that the equity section does not list who owns the stock, only the total dollar value of this section. It is the secretary’s job to record the data and track the ownership of the stock. Based on the above, each share is generally worth $9.62. The shareholder buying at $8.33 a share increases his value by $1.28 per share. The other shares bought for $10 each lost 38 cents of value. In effect, value transferred from the beginning owners to the newer owner. This is often referred to as risk or wealth shifting.
The second area of the report deals with the value increased or decreased due to operations over time. This is referred to as Retained Earnings.
Retained Earnings
As the company conducts business, it earns money. If the idea or if the owners have some type of new way of doing business or they just flat-out do it better than the next company, there should be a positive earnings for the company. This is referred to as the retained earnings. For small businesses, it starts out as current earnings; that which is earned in the current accounting cycle (typically the current calendar year). At the end of the accounting year, those dollars earned roll up into the retained earnings line and the company has a number for the current earnings in the new calendar period. Thus, the equity section would look something like this in the second year of operations:
XYZ, Inc.
(DATE)
Equity Section
Common Stock
Par Value – 50,000 Shares Authorized, 13,000 Sold/$1 Par Value $13,000
Capital Paid in Excess – (13,000 shares sold) 112,000
Total Common Stock $125,000
Retained Earnings
Prior Period Earnings (AKA Cumulative Earnings) 9,214
Current Earnings to Date (Current Calendar Year) 8,149
Total Retained Earnings 17,363
Total Equity (Stock & Retained Earnings Combined) $142,363
Note that the value per share for the company is now ($142,363/13,000 shares) $10.95. The shareholders call a meeting to discuss. At this meeting they agree that business is going great and that they should issue a dividend or some type of cash reward to the owners. They agree to 10 cents per share for a total dividend payment equal to 13,000 shares times 10 cents or $1,300 total. The shareholder that bought 3,000 shares receives a dividend payment of $300. Now the equity section of the balance sheet will reflect this new information as follows:
XYZ, Inc.
(DATE)
Equity Section
Common Stock
Par Value – 50,000 Shares Authorized, 13,000 Sold/$1 Par Value $13,000
Capital Paid in Excess – (13,000 shares sold) 112,000
Total Common Stock $125,000
Retained Earnings
Prior Period Earnings (AKA Cumulative Earnings) 9,214
Current Earnings to Date (Amount in Current Calendar Year) 8,149
Total Retained Earnings 17,363
Dividends Paid (10 cents per share authorized and paid) (1,300)
Total Equity (Stock & Retained Earnings Combined) $141,063
Note that dividends paid continue to be a part of retained earnings and not a separate section by itself. Dividends are paid from what the company earns, not from the original purchase price paid. The new share value is $141,063 divided by 13,000 shares or $10.85 each; exactly 10 cents less each than prior to the authorization of the dividend.
The above is an introduction to the equity section of a typical small business balance sheet. It is designed to illustrate for the new owner the respective two main elements of Stock and Retained Earnings. By understanding these two main elements, the new business owner can better understand his own balance sheet. Act on Knowledge.