How to Read Financial Reports for Equity
The final piece of the balancing equation for financial reporting is equity. All companies are owned by somebody, and the claims that owners have against the assets the company owns are called equity. In a small company, the equity owners are individuals or partners. In a corporation, the equity owners are shareholders.
Stock represents a portion of ownership in a company. Each share of stock has a certain value, based on the price placed on the stock when it’s originally sold to investors. The current market value of the stock doesn’t affect this price; any increase in the stock’s value after its initial offering to the public isn’t reflected here.
The market gains or losses are actually taken by the shareholders, not the company, when the stock is bought and sold on the market.
Some companies issue two types of stock:
Common stock: These shareholders own a portion of the company and have a vote on issues. If the board decides to pay dividends (a certain portion per share it pays to common shareholders from profits), common shareholders get their portion of those dividends as long as the preferred shareholders have been paid in full.
Preferred stock: These shareholders own stock that’s actually somewhere in between common stock and a bond (a long-term liability to be paid back over a number of years). Although they don’t get back the principal they pay for the stock, as a bondholder does, these shareholders have first dibs on any dividends.
Preferred shareholders are guaranteed a certain dividend each year. If a company doesn’t pay dividends for some reason, it accrues these dividends for future years and pays them when it has enough money. A company must pay preferred shareholders their accrued dividends before it pays any money to common shareholders. The disadvantage for preferred shareholders is that they have no voting rights in the company.
You may also find Treasury stock in the equity section of the balance sheet. This is stock that the company has bought back from shareholders. Many companies did that between 2008 and 2013, so look for that on balance sheets. When a company buys back stock, it means less shares on the market. With fewer shares available for purchase on the open market, stock prices tend to rise.
If a firm goes bankrupt, the bondholders hold first claim on any money remaining after the company pays the employees and secured debtors (debtors who’ve loaned money based on specific assets, such as a mortgage on a building). The preferred shareholders are next in line; the common shareholders are at the bottom of the heap and are frequently left with valueless stock.
Each year, companies make a choice to either pay out their net profit to their shareholders or retain all or some of the profit for reinvesting in the company. Any profit a company doesn’t pay to shareholders over the years accumulates in an account called retained earnings.
You don’t find this line item on a corporation’s financial statement, but you’ll likely find it on the balance sheet of a small company that isn’t publicly owned. Capital is the money that the company’s founders initially invested.
If you don’t see this line item on the balance sheet of a small, privately owned company, the owners likely didn’t invest their own capital to get started, or they already took out their initial capital when the company began to earn money.
Drawing is another line item you don’t see on a corporation’s financial statement. Only unincorporated businesses have a drawing account. This line item tracks money that the owners take out from the yearly profits of a business. After a company is incorporated, owners can take money as salary or dividends, but not on a drawing account.