Introduction to Financial Statement Analysis: Statement of Equity

In the last two posts, we looked at the balance sheet and the income statement of a company. They give a direct view on the current status of a company and an overview of the company’s performance over a marked period. In this week’s post, we will look at the statement of stockholder’s equity, the sheet of information stockholders probably care the most about, because it has got to do with the dividends investors receive, the value of stock they hold, and the structure and dynamics of a company.

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Above is an example of a statement of stockholder’s equity. It records the changes of three categories that mount to the total amount of equity a company owns: contributed capital, retained earnings, and other. Contributed earnings represent the part of equity (cash and assets) earned from the sale of a company’s stocks. Retained earnings is the sum of all of a company’s net income ever that had been reinvested into the business, or in other words, the sum of total net-income over the years minus the sum of total dividends ever paid. Others stands for the equity that’s not part of a company’s operations, such as treasury bonds. (To learn more about treasury bonds, click here.)

The variables that change the three categories of equities are stock issuance, net income, dividends, and others. It is quite intuitive that stock issuance contribute to the changes in contributed capital. It could be either positive or negative, depending on if the company sold more or repurchased more of its stocks over the marked period. (Note: On a financial statement, a negative changed is represented by a number in the parenthesis.) Both net income and dividends contribute to the changes in retained earnings as it is defined.  Net income adds to the original retained earnings, and dividends are subtracted from original retained earnings. The sale or purchase in treasury bonds, or cash flow in other financial activities unrelated to the business operation of a company, contributes to the changes in “other” category. On the top of the statement of shareholder’s equity, there is the status of contributed capital, retained earnings, and other at the beginning of the marked period, and on the bottom there are the three categories after the changes during the marked period. (Learn more about share dilution, click here.)

Why is this sheet of information so important? Because it is very much related to the investors’ interest. The amount of stock issuance (or repurchases) is a big factor of the stock price of a company despite from its own performance. When a company issues more stocks, that means there are more shares of the company available in the market, which reduces the value of an investor’s already owned shares. This is called a share dilution. It’s like if you were the only person in the world that has clean water and suddenly 10 more people also discovered and owns water, the value of your water now decreases. Share dilution can be understood in the fundamental “supply and demand” model in economics. The higher the supply, the lower the price. In contrast, the lower the supply, the higher the price. Therefore, when a company repurchases its own stocks from the market, it drives up the value of each individual share held by investors.

There can be further implications about the stock issuance. When a company issues more stocks, it usually means that it needs more cash for expansion and capital investment. Depending on your confidence and judgement of the company’s decision-making, you can sell your shares of the company or purchase more of them. If you don’t believe Nike’s investment in the Chinese sportswear market would yield profit, then it’s better to sell your stocks early before Nike stumble hard on this big spending and the stock price drops. If you believe otherwise, which I do, then it’s a perfect time to buy in the newly  issued stocks cheap.

The amount of dividends paid by a company is more straight forward. Investors are paid with dividends as their interest in investing in the company. However, we often see a zero in the dividends entry on a equity statement. That doesn’t mean the company is not paying its shareholder’s interest. The company is paying the investors by investing in itself, improving performance, and thereby driving up the share value. Depending on if you are a dividend stock investor or a value stock investor, this piece information can very much affect your decision.

(To view a real statement of stockholder’s equity of Nike and Disney, click here.)

 

 

Citation

P1: http://www.slideshare.net/Ellena98/module-1-financial-accounting-for-mbas

 

 

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