Corporations receive equity investments from shareholders and also create equity by retaining profits from their operations. Over time the company's total equity fluctuates in response to transactions. This generally does not indicate a problem, but a once-stable company experiencing repeated reductions to total equity should be evaluated with caution.
Total equity represents the total money received from investors plus a corporation's accumulated earnings. Put differently, total equity equals a firm's assets minus its liabilities. The total stockholders' equity section is on the bottom of a corporation's balance sheet. This section shows detailed accounts for common stock, preferred stock, treasury stock, paid-in capital, dividends paid and retained earnings.
Total equity can increase on the balance sheet whenever a company issues new shares of stock. If the company receives donations of capital from owners or other parties, this also increases total equity. One other common increase in total equity results from an increase in the company's retained earnings. At the end of each year, an accountant moves the company's annual net income from the income statement over to the balance sheet's retained earnings account, increasing total equity.
Corporations decrease their total equity when they pay dividends to shareholders. Preferred stock often comes with quarterly or annual dividend payment obligations the company must fulfill. The payments directly reduce the company's retained earnings in the stockholders' equity section of the balance sheet, causing a drop in total equity. If a company experiences a net loss in any given year, this also reduces total equity when the year's losses are transferred from the income statement to the balance sheet. When equity decreases because of dividend payments, a few years of negative earnings for a start-up venture or one bad year of earnings because of an extraordinary event, it's not generally a bad sign. When an established company has decreasing equity because of net losses year after year, especially if it does not pay dividends, the company could be having cash flow or other financial issues it cannot recover from and investors should investigate other financial data such as the company's working capital (total assets minus total liabilities), inventory turnover and debt ratios to determine the company's future viability.
Companies periodically repurchase their stock. This occurs when company management believes the stock is undervalued by the market, or when the company has a surplus of cash. This use of cash and repurchase of shares decreases total equity in most cases. Companies that issue stock options to employees must protect the stock from dilution. As each employee exercises options, more shares of stock exist, making previous shareholder investments worth less as a percentage of the overall company. Companies remedy this by repurchasing enough shares to offset the dilution. In this case, total equity could remain relatively the same.