Equity Types: Not Created Equal

Let’s imagine you have two prospective borrower’s in front of you, you can only choose one, and all you have to make your decision is their balance sheet.  To make matters even more difficult, the amount/type of assets and the amount/type of liabilities are identical.  How do you choose?  Aren’t they the same?

A balance sheet is essentially a summary of all past decisions jumbled together, but one key attribute of a balance sheet is that it is as of a specific point in time.  So what difference does that make?  Well, think if you are looking at a businesses income statement, and you only had one to look out.  Is their revenue good?  I don’t know.  How about expenses (raise and lower shoulders)? Net income?  Not a clue.  The basis of financial analysis is to look at trends, and it is impossible to see a trend in an income statement without at least one (preferably two) other statements to compare against.  Let’s get back to our scenario.  We only have one balance sheet to look at; so a trend analysis isn’t possible, right?  Not exactly.  Let’s explore the different types of equity on a balance sheet and explore if we can see how a business accumulated what is on their balance sheet.

What are the different types of Equity

When bankers think about equity, they typically just think of the difference between Assets and Liabilities.  This isn’t wrong, but by simplifying the equity calculation, we lose some valuable insights.  For well prepared balance sheets, equity is broken down into 3 categories: Common Stock, Additional Paid in Capital and Retained Earnings.  A business’s total equity is the sum of these three components.  Let’s explore what each of these are and what they mean to a community banker.

Equity Type: Common Stock

Common Stock (AKA Capital Stock) is typically the initial amount of investment put into a business by its owners when the business was first created.  In most small cases, this number will not change over time.  

Equity Type: Additional Paid in Capital

Additional Paid in Capital is the aggregate total as of the date of the balance sheet of all ADDITIONAL money the owners have put into the business since inception.  This number will typically only increase over time as additional contributions into the business are made and the total increases.  Since the number as of the balance sheet date just reflects the sum of all dollars contributed up to that point (so even if the contribution was made 30 years ago, it will still be in that number), you can tell whether the business owner injected additional money if this value increases from one balance sheet date to the next (the difference between the first and second balance sheet’s value is how much money the owner contributed).

Equity Type: Retained Earnings

The last form of equity is Retained Earnings.  What Retained Earnings represents is the sum of all historical earnings that have not been distributed out of the business to its shareholders.  The change in retained earnings from year to year will be based on how much income the business made less how much the owners took out as distributions from the business.

Why does this matter?

Let’s go back to our example.  A balance sheet is a snapshot in time, but a trend is preferable.  What we just discovered is that there is essentially a “trend” built into the equity area of the balance sheet.  Let me explain by showing an example below where both companies have identical total equity.

In this example the two business’s total equity is the same at $1,000,000, but that is where the similarities end.  By diving deeper into the three equity types, we can get a glimpse into “how” they accumulated the equity that they have.  In the case of Company B, their equity was built through profitable business operations over their history; whereas Company A’s equity is really just showing you how much is left after they lost a portion of the large amount of capital they raised.  Now which borrower would you prefer?  

Conclusion

By simply looking at total equity, you may be missing a valuable piece of information: how did the borrower get to where they are?  Did they do it by performing profitably?  Did they lose the capital they began with?  Are they the business equivalent of a trust fund baby?  Knowing “how” a business got to where they are is just as (if not more) important than where they are at now.