Why Equity is a Liability

As shareholders own the equity of a business it is a liability. Equity + current + long term liabilities define how total assets are supported.

Equity as a Liability

The equity of a company represents its capital. It is also known as shareholders funds.

Equity represents the direct investment in the company made by its shareholders / stockholders by way of paid up share capital. Retained profits are added to this as they are deemed to have been re-invested until such time as they may be distributed as dividends.

A Company Cannot Own Itself

As a result of the above the equity of any company represents a financial obligation to its shareholders, who are the owners of the business.

It always balances against net assets in the balance sheet. If equity / net assets are in deficit the company's total liabilities will not be covered by the value of its assets and is therefore insolvent. In practice however insolvency can easily arrive well before that situation arises.

Liquidity / Working Capital

Positive equity / net assets do not always represent solvency. The much narrower measurement; net current assets broadly defining working capital, which in turn defines liquidity is the sole source of cash flow from the core trading (operating) activity of a business.

Net current assets are measured by cash and current assets such as accounts receivable and stock / inventory that are readily convertible into cash within twelve months less current liabilities i.e. debt payable within twelve months.

Negative Liquidity / Working Capital

A balance sheet forecast showing working capital in deficit simply signifies an inevitable cash flow crisis.That is why when producing financial forecasts using Figurewizard, positive net current assets are essential if the business is to be forecasting survival for the year or years ahead.

The value of fixed assets play no part in calculating liquidity but any debt attached to fixed assets which is payable within twelve months is included in current liabilities and is therefore a charge against working capital / liquidity.

In the event of a deficit for net current assets new paid up share capital and or loans (preferably long term loans) would be called for to plug the gap. These would only represent a short term solution though; in the longer term, enacting a business plan forecasting a future surplus of current assets over current liabilities will be absolutely crucial.

Dividends: Equity and Cash Flow

Just as excessive overheads will degrade profits, excessive dividends will degrade both equity and cash flow, norwithstanding positive equity / net assets.

The fact is that the level of profits in the balance sheet alone does not justify dividends if they subsequently cause the business to run out of cash. Decisions on the level of dividends in the current financial year must also depend on their effects on forecast liquidity and cash flow solvency over the next.

Planing and Forecasting with Figurewizard

Forecasting this is just as important for any business that is planning for expansion as it is for one that is planning for survival or recovery. That is what Figurewizard is designed to do. To view some of the forecasts Figurewizard produces, select from the menu to the left.

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