Stockholder equity and liability are the sole sources of funds in a firm. The ratio between equity and liability is critical, since it influences the firm's long-term viability. Firms with excessive liabilities may run into severe trouble, even if they are otherwise successful entities.
Stockholder equity, also known simply as equity, is the portion of the firm that is owned by the shareholders. This number appears on the right-hand side of a typical balance sheet and is comprised of equity plus retained earnings. In other words, shareholder equity equals the cash that the owners of the firm have initially contributed, plus all accumulated and as-yet undistributed profits. Note that the actual worth of all outstanding shares, also known as market capitalization, usually exceeds the stockholder equity figure reported in the balance sheet. The value of certain intangible assets, such as the brand name, expertise of the employees, trust built with suppliers and so on, enhance the value of the stock but are not reflected in the shareholder equity figure.
Liabilities include all payment obligations of a firm. The money owed to suppliers, the bank loan that is due in a year, payment obligations arising from bond sales and wages of employees that have been earned but have yet to be paid out are just some of the various types of liabilities a typical firm has on its balance sheet. Liabilities are also on the right-hand side of a typical balance sheet, and the sum of liabilities and shareholder equity are equal to assets, which are on the left side of the balance sheet. This is because everything that is owed, in other words assets, must be owned by either creditors or stockholders.
In finance, the term leverage refers to the ration between the firm's liabilities and equity and is calculated by dividing total liability by shareholder equity. Note that some analysts prefer to use only long-term liabilities, which are payment obligations coming due in one year or more, when calculating leverage. The more common leverage formula, however, incorporates all liabilities. If stockholder equity is less than total liability, the firm's leverage ratio will be greater than 1. While there is no magical cutoff for leverage, a ratio exceeding 1 generally means that the firm has a lot of debt. At what point the debt level gets dangerously high depends on the industry the firm operates in, when exactly the debt comes due and the firm's ability to generate cash from its operations to pay its liabilities.
Dangers of Excess Debt
The problem with too much debt is that unpaid debt obligations can result in legal action against the firm. If a firm's cash is coming primarily from shareholders and the company fails to generate sufficient cash to pay a dividend to these shareholders, the result is merely a bunch of angry investors. Shareholders can replace the management team during the annual shareholder meeting, but except in the case of severe mismanagement and gross neglect, cannot take legal action against the firm. Creditors, on the other hand, can sue the firm for unpaid debt and even force it into bankruptcy.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.