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

Also known as equity, shareholders’ funds represent the sum owed by a company to its shareholders - That makes it a liability.

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

Share Premium Account

When a company sells shares to an investor for more than their issued face value, the difference between the sale value and the face value of the shares is shown in the balance sheet as a "share premium account".

A Company Cannot Own Itself

A company is recognised under the Companies Act as a unique entity in law, independent of shareholders and management. Equity represents its financial obligation towards its shareholders, who are the owners of the business.

Insolvent Balance Sheet

Equity balances against net assets in the balance sheet.

A deficit means that the company's assets are unable to cover its liabilities, making it techinically insolvent. In practice however insolvency can arrive well before then.

Liquidity / Working Capital

Positive equity / net assets do not always represent solvency. A narrower measurement, net current assets known as working capital is the source of liquidity - Liquidity is the sole source of cash flow from core trading (operating) activity.

Net current assets represent cash plus current assets such as accounts receivable and stock / inventory expected to be cash convertible 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 .signifies a future cash flow crisis unless it is addressed. That is why when producing financial forecasts using Figurewizard, positive net current assets are essential if the business is to avoid difficulties.

Note that Fixed assets play no part in calculating liquidity but debt attached to them, due for payment within twelve months does.

An injection of capital or loans (preferably long term). will avert a crisis arising from negtive working capital but such measures are a temporary expedient. Debt does not cure cashflow insolvency.

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 therefore depend on the effect on liquidity and cash flow solvency going forward.

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 in a simple, straightforward and affordable manner. To view samples of the forecasts Figurewizard produces, select them from the menu to the left.

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