Stockholders' equity, the value of a firm's assets minus the company's total liabilities, has two key sources. The initial building block of stockholders' equity is paid-in capital. The other main source of stockholders' equity is accumulated retained earnings. Investors should be aware that stockholders' equity can decline as well as increase.
One of the two main sources of stockholders' equity is paid-in capital. Paid-in capital is the money brought into the business by selling stock in the company. These funds are often the initial source of stockholders' equity. Over time, firms might sell additional stock to raise money for various reasons. For example, a company might need funds to expand into a new market. When more stock is sold, the firm's stockholders' equity increases.
Retained earnings are the other main source of stockholders' equity. Retained earnings are made up of the accumulated yearly profits earned by the firm, minus any dividend payments. For example, if a firm records a net profit of $100 million at the end of 2012, then the stockholders' equity on the balance sheet increases by the same amount. These profits are a reflection of how successful a company has operated over time.
In addition to paid-in capital and retained earnings, there are other sources of stockholders' equity. For example, a business might own a subsidiary with foreign currency earnings. Sometimes, when the currency is converted to U.S. dollars there is a gain. This gain increases stockholders' equity. Another source of stockholders' equity is unrealized gains of securities the firm is holding to sell. The common feature of these types of sources is that they do not reflect the firm's core operations.
Warning: Stockholders' Equity Can Drop
Investors should be aware that stockholders' equity can also decline. The most common reason is operational losses. When a firm records a net loss for the year, the amount is subtracted from retained earnings. Another reason stockholders' equity can drop is dividend payment declarations. Stockholders' equity can also decline if a business decides to repurchase shares. This action reduces cash on the balance sheet, and subsequently it reduces the value of stockholders' equity.