The Importance of Stockholders' Equity

Investors typically prefer corporations as investment vehicles. Corporations provide liability shielding and make it relatively easy to buy and sell shares. For this reason, business owners who intend to raise capital most often choose the corporate structure to do so. Owners in a corporation are called stockholders. Corporations exist is to provide value to their stockholders. This value is reflected in stockholders' equity.

Stockholders' equity, also called shareholders' equity, is the owners' equity in the corporation. It appears on a corporation's balance sheet and reflects the owners' interest in the corporation. You are a stockholder whether you hold or own one share of stock in a corporation or 100 percent of the outstanding shares and are the sole owner. The shares you own, whether actual physical shares or shares documented on paper, reflect your ownership in the corporation.

On the balance sheet, assets less liabilities equal stockholders' equity. Therefore, stockholders' equity is also referred to as net worth. Stockholders' equity records how much you and other co-owners or investors have contributed to the corporation through the purchase of shares. These include any initial contributions and any additional paid-in capital. Stockholders' equity also reflects the profits your corporation has retained or distributed to shareholders. The profits retained or losses accrued are called retained earnings, and the shareholder distributions are called dividends.

Contributions and paid-in capital are monies that owners and investors contribute to the company in exchange for profits generated or an increase in the company's value. With common stock, the company makes no guarantees for these equity contributions. Equity shareholders provide funds that enable your company to perform actions such as acquiring assets, hiring personnel, or paying for marketing, with no or limited concerns about how to pay it back. Therefore, equity contributions only enhance cash flow.

Retained earnings reflect both net profits and net losses. Net profits increase retained earnings while net losses decrease retained earnings. Once your corporation is profitable, you can use the retained net profits to build and grow the company. You can reinvest profits into business expansion or use them to further strengthen infrastructure and enhance productivity.

A corporation that has been operating profitably for a number of years will show a large balance under the retained earnings component of stockholders' equity. This assumes that the company did not distribute much of these profits to shareholders as dividends. This high level of stockholders' equity indicates your corporation’s long-term profitability and focus on reinvestment to a lender or investor looking at your company. Since lenders focus on debt-to-equity ratios when assessing credit worthiness, a high stockholders' equity number reduces this ratio, making your company more attractive for loans.