Because stockholders’ equity corresponds to the net worth of a company, any fluctuations in the earnings of the company also affect the equity. Since operating costs and other expenses offset earnings, those expenses affect stockholders’ equity as well by lowering the net assets, or profits, that a company earns in a year.
Any expense that a company incurs during normal operations decreases the company’s net earnings for a year, which decreases the amount by which the net worth of the company increases during that year. Expenses do not encompass operating costs alone, though. Any money that a company chooses to pay out, such as stock dividends to shareholders or donations to charity, also becomes an expense and decreases assets, which affects stockholders’ equity.
In many cases, a company’s stockholders’ equity and a company’s net worth will be equal, but there are some exceptions to this. Since all financial planning of a company is left to the company’s board, and rules don’t dictate that a company must make all net worth available as stockholders’ equity, a company may keep a portion of its total assets separate and not include it as part of stockholders’ equity. Creditors who lend the company money may also place restrictions on those funds that prevents the money from being included in a company’s assets for stock purposes.
Why Stockholders’ Equity is Important
Though net worth can help an investor determine the value of a company and how likely that company is to continue growing and building profits, it does not determine stock-specific things, such as share prices and dividends. As far as the stock market is concerned, a company’s stockholders’ equity represents the company’s value, and when a company determines dividends, it does so based on the total stockholders’ equity and not the total net worth.
Dividends and Donations
Since the board members of a company may choose to spend money without the knowledge of shareholders, such as making charitable donations, it may seem wise to avoid companies that add unnecessary expenses. Many of these donations are tax-deductible, however, which means the company may actually be making a wise financial move when it donates. Though dividends also bring down the company’s shareholders’ equity, that money pays out directly to shareholders, so, although it decreases long-term equity, it results in a short-term gain for anyone who holds stock.