In accounting, there is one overarching equation, often expressed as: assets minus liabilities equals stockholders' equity. This equation makes it seem as though stockholders' equity -- also known as owners' equity, shareholders' equity, or SE -- is an afterthought, whatever happens to be left over at the end of the day. To leave it at that would trivialize the importance of stockholders' equity to a company's health.
Origin of Stockholders' Equity
To transform an idea into a thriving corporation, businesses they need money. This capital can come from the owner of the company or from other people. It can be an investment or a loan. The initial capital from an owner is an investment. By creating and running a business, that person owns the company and owns the right to its profits, whatever they might be. This is the original stockholders' equity.
Addition to Stockholders' Equity: Stock Issue
As a company grows, it might accept capital from outside investors in exchange for partial ownership and the right to profit. If the company does this with many people, it becomes a corporation, and ownership is represented by shares of stock. The initial capital received for shares is added to the stockholders' equity, whether or not the company issues that stock publicly. This process is repeated if the company issues additional shares.
Addition to Stockholders' Equity: Assets
Companies use the capital from stockholders to buy equipment and inventory. These assets increase stockholders' equity for as long as their total value is greater than that of the company's liabilities. Physical assets change value over time: Inventory is used up, and equipment depreciates. With a healthy company, this reduction in value is offset by an increase in profit, so shareholders might not see much fluctuation in value from this source.
Addition to Stockholders' Equity: Retained Earnings
As the company makes a profit, it can distribute that profit to stockholders as a dividend, or it can keep it to reinvest in its activities. If it keeps the profit, it is called "retained earnings" and is added to the total stockholders' equity.
Decreases in Stockholders' Equity: Liabilities
Liabilities are primarily loans and bonds that the company must pay back in the future. These decrease stockholders' equity because they will decrease total profit. On a balance sheet, liabilities can also include short-term accrued expenses, such as salaries and bills that haven't been paid yet. As long as a company's total assets are greater than its total liabilities, the company has positive stockholders' equity.
Statement of Stockholders' Equity
The statement of stockholders' equity is a snapshot calculated by subtracting all liabilities from all assets. It is, in some ways, the net worth of the company -- what stockholders would receive if the company were sold for book value on the day of the report.