What Causes the Erosion of Stockholders' Equity Amounts?
Original post by Dennis Hartman of Demand Media
In financial accounting, stockholders' equity is among the key pieces of data that investors, analysts and business leaders use to learn about a company and estimate its value. Many factors play into stockholders' equity, and changes throughout a business's operations or industry can erode the stockholders' equity amount.
Stockholders' Equity Equation
Accountants use a simple formula to compute the stockholders' equity of a given business at a specific point in time. Stockholders' equity equals the business's total assets minus its total liabilities. Assets include cash reserves, property such as buildings and land, patents, merchandise inventories and investments. Liabilities include all types of debt and immediate costs such as taxes and payroll. This means that any factor that increases a business's liabilities, or decreases the value of its assets, erodes stockholders' equity.
Over time, many of a business's assets depreciate, or lose value naturally. This is true of things such as factories and manufacturing equipment, which are at the peak of their value when brand new. Their value depreciates as they age. Businesses can write off depreciation as an operating expense, but depreciation still erodes equity by reducing the value of key assets. Businesses can guard against this by spending on capital improvements, which add to the value of existing assets by repairing or modernizing them.
Normal business activities such as borrowing and spending money can also erode a business's stockholders' equity amount. When a business borrows money, it can purchase assets worth the same amount as the principal it borrows. However, the interest on the loan becomes a liability, decreasing stockholders' equity until the new assets grow in value or the business pays off its debt.
Debt often comprises the bulk of a business's liabilities, which means that commercial borrowers are subject to the same swings in interest rates, and the resulting charges, as mortgage borrowers and credit card users. A business that borrows millions of dollars using a variable rate loan to build a new factory can see its monthly interest payments rise substantially if interest rates rise even a fraction of a percentage point. Businesses that experience financial hardship may not be able to get access to low rates, which increases the cost of borrowing and erodes stockholders' equity even further.
About the Author
Dennis Hartman is a freelance writer living in California. His work covers a wide variety of topics and has been published nationally in print as well as online. Hartman holds a Bachelor of Fine Arts from Syracuse University and a Master of Arts from the State University of New York at Buffalo.