- September 9, 2020
- Posted by: saenicsa
- Category: Accounting
There are 2 ways to finance a company, either through external creditors or from within – we are referring to the shareholders.
It is important for a company to manage well what their obligations are to both creditors as also shareholders. This is especially true when starting out since it is important to manage this well, because if not then many problems can result later on.
Therefore, today we are going to talk about the information we can get from the Equity section of our Balance Sheet.
When you see under the Equity section of your Balance Sheet, “Retained Earnings”, this is a very interesting indicator with relation to the business that you should pay attention to every once in a while.
What do I mean? Well, retained earning refers to the accumulated loss or profit that a company has accumulated year after year. This includes both profits and losses.
It is important to look at this figure because it will be able to tell us, fairly directly, how profitable company has been…up to a certain point.
Why? Well, we say up to a certain point, because there are a few things that you would need to keep in mind first, before judging on the profitability of a company, for example:
1) Accumulated profits from previous years can be affected by just one bad year; and
2) Retained earnings will de reduced when dividends are paid out or the profits are used for other purposes.
Therefore, it is important not to over analyze retained earnings or use the retained earnings line from just one year by itself without comparing to between prior periods.
On the other hand, there is a very important warning we can get from retained earnings, and that is if the accumulated losses are greater than rest of equity, technically the company is bankrupt, and if the shareholders cannot provide additional capital, then the company would be officially bankrupt.
Additional Capital & Capital
Talking about additional capital, on the Equity section of our Balance Sheet we can also see this.
What exactly is additional capital? Well additional capital is money that the shareholders have made available for the company to stay solvent.
And the reason it is called additional capital is because as required by law, when a company is incorporated, there needs to be an initial capital offered by the founding shareholders.
Of course, it is difficult to foresee future problems in a new business so there may be occasions where the original amount of capital is not sufficient to cover the liabilities that the company may need to pay.
Therefore, as the name implies the shareholders may authorize additional capital to assure the solvency of the business.
Other Comprehensive Income
Now another interesting item that we may find on the equity section of the Balance Sheet is “Other Comprehensive Income”.
What does this mean? This is uncommon to find, but when you do find it on a company’s Balance Sheet it is usually due to there being revenues, costs and other gains and losses excluded from net income.
This means that for example, as we mentioned in a previous article, if a company owns a brand name, to ascertain the value of that brand a company would need to hire a professional that can estimate the value. This estimate by no means remains unchanged, therefore it can increase and decrease from year to year due to many different factors. But, let us say that from one year to another there was an increase, the brand value rose, how would this be reflected on your balance sheet? Well, it would be shown on none other than, Other Comprehensive Income.