Evaluating Financial Statements – Statement of Shareholder Equity

by Begin To Invest on July 16, 2014

We have previously discussed the more well known financial statements; the balance sheet, income statement and statement of cash flows, but there is one additional financial statement you will see listed within every company’s 10-k report, the statement of shareholder equity. Value investors like Warren Buffett consider information within this report as some of the most important and telling signs of a company’s health. Here is why:

Shareholder Equity – What is it?

Recall the most basic equation in finance:

Assets = Liabilities + Shareholder Equity

Or, said another way:

Shareholder Equity = Assets – Liabilities

So really, shareholder equity should be considered the net worth of the company, or what the company is worth if all its assets were sold and debts settled.

The Statement of Shareholder Equity depicts the value of the company and describes where that value comes from and how it has changed over time for investors.

Let’s take a look at an example and define some key terms before delving deeper. Below, we show WD-40 company’s (Ticker: WDFC) statement of shareholder equity from their latest 10-k report. If you are unsure of how to locate these statements, read our guide on evaluating the balance sheet where we describe step by step how to obtain these reports.

Click to enlarge – there is a ton of information on the statement

As you may notice, most of this information is also located at the bottom of the company’s balance sheet:

The Statement of Shareholder Equity is made up of a few main items:

Common Stock – This represents the value of all issued shares at par value. The concept of par value of a share is somewhat out of date today. It has nothing to do with the actual value of the shares today, and only represents the how much capital was paid in for each share by the original subscribers of the stock. This par value dealing with common stock is entirely different than the par value related to bonds.

Additional paid in capital – This represents money the company received from issuance of its shares in excess of their par value. For example, if WD-40 Company issued 100,000 shares at $50, it would record an additional paid in capital of $499,990 [($50 – $0.001) * 100,000]

Retained Earnings – This is a cumulative total of the money the company has left over after all expenses are paid (net income). Retained earnings can be invested back into the company, used to pay dividends, or buy back its own stock.

Treasury Stock – Treasury stock are shares that the company has bought back and are holding to be either re-issued (for stock awards as part of employee plans, or general share issues to raise capital) or to be retired. Notice that the value of the company’s treasury stock is subtracted from shareholder equity. This is because the company’s shares are not considered assets to the company, and the company must use its cash, which is an asset, to repurchase those shares. In order to keep the balance sheet in ‘balance’, treasury share value must be subtracted to match the value of the cash used to acquire those shares.

For categories similar to ‘other comprehensive income (loss)’, read the notes to the company’s financial statements to understand what is included in this category. For WD-40 Co., this represents gains or losses due to foreign currency exchange.

Changes in Shareholder Equity

So, Shareholder Equity is really just the sum of investments made into the company (common stock + paid in capital), plus any past net income (Retained earnings) minus dividends paid and money used to repurchase shares (treasury stock).

A company’s Shareholder Equity increases when a company books a profit (has a positive net income – which adds on to retained earnings), or when a company sells additional shares to investors (which increases paid in capital).

A company’s shareholder equity declines when the company takes a loss (has a negative net income – which lowers retained earnings), pays a dividend to shareholders or buys back its own stock.

Financial Ratios Based On Shareholder Equity

There are several commonly used ratios that use information from the statement of shareholder equity.

Return on Equity (ROE)

Calculating return on equity is one of the most common ways to calculate the effectiveness of a company’s management to create a return for shareholders. (Investors like Warren Buffett frequently cite this calculation as evidence of a strong competitive advantage and a successful enterprise).

Return on Equity is calculated by dividing the company’s net income by its shareholder’s equity:

ROE is generally shown as a percentage. The higher the percentage, the more efficiently management is creating profits for its shareholders.

Click the link above for our definition page on ROE for much more detail on ROE, its uses and what to watch out for when calculating ROE.

Leverage

Leverage ratios are calculated when evaluating a company’s solvency. Calculating a company’s leverage ratio measures the extent that a company uses liabilities, instead of equity to fund its assets. A higher level of leverage means that the company has a lower level of solvency, and possesses more risk to investors.

There are a couple of alternatives to calculate leverage based on shareholder equity:

Debt to Equity Ratio:

Where a company’s debt to equity ratio is calculated by dividing total debt of the company by the company’s shareholder equity:

If a company has $2 billion in debt, and $1 billion in shareholder equity, it would have a debt to equity ratio of 2. The higher this ratio the weaker solvency the company has.

Another calculation of a company’s leverage is the Financial Leverage Ratio:

Here once again, the higher the ratio the more leveraged, and weaker in terms of solvency the company is.

General Use of Statement of Shareholder Equity in Investing Analysis

A company’s shareholder’s equity portrays the company’s value. For this reason it is heavily scrutinized by value investors, the most famous of which is Warren Buffett who uses the Return on Equity calculation we found above in his search for investments. To quote Warren Buffett and the Interpretation of Financial Statements:

“What Warren discovered is that companies that benefit from a durable or long-term competitive advantage show higher than average returns on shareholder’s equity. Warren’s favorite, Coca-Cola, shows a return on shareholder’s equity of 30%; Wrigley comes in at 24%; for she earns a delicious 33%; and Pepsi measures in at 34%.”