Finance interview question: Can a company have negative Equity?
This week we are introducing a new type of article. We will present corporate finance interview questions from areas such as Private Equity, Transaction Services, or Investment Banking. Of course, we will also provide the answers. Today’s question is a classic accounting question: Can a company have negative Equity?
Before we start, what is Equity?
Equity refers to what a company owes to its shareholders. The simplest way to calculate equity is to subtract debt from the company’s total assets based on the balance sheet principle (assets = liabilities).
Nevertheless, for your understanding, here are the components of the Equity:
- Share capital, which represents the resources contributed by shareholders in exchange for shares.
- Capital reserve, which is the accumulation of previous years’ profits that haven’t been distributed to shareholders as dividends and are retained within the company.
- Retained earnings, which are similar to the capital reserve, but reflect the accumulated results of previous years that haven’t been allocated yet between dividends and capital reserves.
- Earnings from the current year.
Can Equity be negative?
To answer this, we need to examine the components of equity:
- The share capital must be positive or equal to zero.
- On the other hand, the earnings from current or previous years can be negative.
💡 This means that in theory, the answer to the question of whether it’s possible to have negative equity is yes. If the earnings are negative, they can decrease equity to the point where it becomes negative. However, in reality, this is a rare occurrence.
Beware of confusion
It’s important to note that shareholder equity and Equity Value should not be confused.
Equity value, which is the market value of equity, cannot be negative. It is calculated by multiplying the number of shares by the price of each share. Both the number of shares and the price per share are positive, making it impossible to have a negative equity value. Thus, it is crucial to differentiate between the book value and market value of equity.
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