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As a first year business student, I have seen a few balance sheets that
reflect negative equity. Can I get a general explanation of this. Is
there
a general feeling among investors on what this situation could reflect?

Thanks,
WBS
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Dear billscally,

Basically book value = assets - liabilities, so as you say, in principle there is nothing wrong with a negative book value ("shareholder's deficit").

In principle "book value" would be the value of a company to shareholders if all liabilities were paid off. The "in principle" comes because it probably isn't so; equipment and inventory likely would have to be sold for less than the value on the books, other things may sell for more (e.g. sometimes real estate, purchased companies).

Ben Graham says that book value is more accurately a measure of the money "put into" a company (shareholder's equity = money from issued stock + paid in capital + retained earnings - treasury stock, possible I'm missing one or two things but these are the main ones). One can make this number negative by paying out quite a bit of equity (e.g. special dividend) or buying back a bunch of shares. The times I have seen it has been the latter (take on debt to buy back a lot of shares).

I see this in LBOed companies sometimes...

Did I answer your question?

Lleweilun Smith
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Are you referring to TOTAL equity or RETAINED EARNINGS?

A negative retained earnings account arises when prior years' net income and loss nets out to a loss. Say company A has income of 100K in the first year has a net loss of 200K in year 2 and a net loss of 100K in year three. The company's retained earnings would equal negative 200K.

It's how the company deals with these losses that matters. If a company continually loses money, it needs to find capital to operate. It has two basic sources - equity or debt.

If equity is the chosen path, then the company will have an increase in its common stock and additional paid in capital accounts. This means that the owners (stockholders) of the business have opted to finance the continuing operations. The balance sheet would (generally)show a positive TOTAL equity. Meaning that the owner's would have a larger claim to the business than the creditors.

If debt is the option of choice, the other components of equity would not change (CS and APIC) and eventually TOTAL equity would go negative meaning that the creditors would have a larger interest in the company's assets than the owners. Not good.

As for what it means in the grand scheme of things, its hard to say. If the business is a typical brick and mortar business, negative RE or equity can't be good for the long term. The company just isn't making money. However, this should be expected of a drug company or other experimental type company that incurrs large expenses up front without any revenue.

Help any?

John...
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Dear y'all,

Just to add to Wiggy's note.

It is possible for a company to earn money yet have a negative shareholder's equity. For example, if a company issues enough debt and uses it to repurchase shares, this could happen. US Tobacco (NYSE:UST) still has a positive book value, but intends to continue to "leverage up" and repurchase shares, and so quite possibly it may drop negative.

In a situation where a company can borrow money cheaply and has steady and predictable earnings, it may make sense to do this. (I must admit, it makes me a bit uncomfortable though). Equity has a high opportunity cost and debt is a tax shield, so sometimes leveraging up makes sense. KKR has put together some successful deals with highly leveraged structures, then proceeded to pay off the debt successfully.

Negative retained earnings leading to negative shareholder's equity though sounds bad...

Lleweilun Smith
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Thanks,
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jmls posted:

It is possible for a company to earn money yet have a negative shareholder's equity. For example, if a company issues enough debt and uses it to repurchase shares, this could happen. US Tobacco (NYSE:UST) still has a positive book value, but intends to continue to "leverage up" and repurchase shares, and so quite possibly it may drop negative.

In a situation where a company can borrow money cheaply and has steady and predictable earnings, it may make sense to do this. (I must admit, it makes me a bit uncomfortable though). Equity has a high opportunity cost and debt is a tax shield, so sometimes leveraging up makes sense. KKR has put together some successful deals with highly leveraged structures, then proceeded to pay off the debt successfully.


Moreover, a history of sucessfully identifying price/value disparities and using leverage to retire shares may indicate a hightened management awareness of true value. This could imply a greater probability that management will make other financial decisions with the aim of increasing long-term shareholder value.

That's getting a bit beyond the financial statement, of course.

-Richard
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One can make this number negative by paying out quite a bit of equity (e.g. special dividend) or buying back a bunch of shares. The times I have seen it has been the latter (take on debt to buy back a lot of shares).

Your explanation is quite good. One small point: a corporation can't pay out a dividend that exceeds the amount in retained earnings. If the corporation has any subsidiaries, any of the subsidiary retained earnings that haven't been distributed to the parent are restricted from dividends.

The most common cause of a negative shareholders' equity is substantial losses that result in a large negative retained earnings balance.

Mike
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Basically, given the simple equasion
Assets = Liabilities + Ownership
the only way Ownership (Equity) goes negative is if Liabilities exceed Assets, or, more properly, if the book value of Liabilities exceeds the book value of Assets.

Yes, there are some leveraged buyout and other "unusual" situation where this may be OK or a reasonable risk, but can anyone name a major corporation in which you would be willing to invest with negative Equity?

Also, Retained Earnings = All Historical Earnings less some portion paid to Owners (shareholders) in the form of All Historical Dividends. That means that the only way to get negative Retained Earnings is that All Historical Earnings is negative (not pretty) or Dividends exceeds Earnings (also not pretty).

In general negative Equity and negative Retained Earnings are to be looked upon with sufficient suspicion that one should probably exit fast enough to leave skid marks.
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Yes, there are some leveraged buyout and other "unusual" situation where this may be OK or a reasonable risk, but can anyone name a major corporation in which you would be willing to invest with negative Equity?

As it's been pointed out, UST is heading in that direction.

-Ortman
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