Stockholder equity -- typically called shareholder equity -- in a company originally consists of the cash and other assets contributed by the founders. As the company engages in various activities, it will either accumulate profits or suffer losses. Its profitability -- and whether management decides to invest profits back into the business or distribute them to shareholders -- will determine the level of retained earnings as well as shareholder equity.
Balance Sheet Basics
Every balance sheet consists of two sides. One side is titled "Assets" and contains a breakdown of all valuables the company owns. Buildings, inventory, raw materials, cash and receivables are all listed together as assets. The other side of the balance sheet is titled "Liabilities" and lists all payment obligations as well as the value of the shareholders' stake in the company. The sum of all assets equals the sum of debt plus total shareholder equity. In other words, the two sides of the balance sheet add up to the same total.
For a company that historically has been profitable, total shareholder equity will consist of the sum of each shareholder's equity plus retained earnings. In other words, retained earnings are part of shareholder equity.
Here's how a profitable company ends up with retained earnings. When a company records a profit the value of assets will go up because a profit means an increase in the value of what you own. To preserve the balance, something must increase on the other side of the balance sheet. An accountant will create a new line item called "Retained Earnings" to ensure balance. Shareholder equity will now consist of two lines: "Shareholder Equity" and "Retained Earnings." If the company previously has been profitable and such a line exists, retained earnings will grow as the company records additional profits.
Treatment of Losses
If the company records a loss, the value of its assets will decline. Again, shareholder equity will have to decline to preserve the balance. If the company has a line labeled "Retained Earnings," the loss will be deducted from this line. Think of a loss as negative earnings, which eat into past earnings before they start to deplete shareholder equity. If after using up all of the retained earnings there is still a loss -- or if there was no retained earnings line to begin with -- the remaining loss will be deducted from shareholder equity.
A company can deplete its retained earnings in two ways: through losses or through dividends, which are distributions of cash to shareholders. When cash is given to shareholders, the assets decrease because there is now less cash on hand. Remember that there must also be a decrease on the other side of the balance sheet. "Retained Earnings" will reflect that decrease, because the portion of earnings that has been distributed in the form of dividends is no longer retained.
Generally, profitable companies will distribute some part of their earnings as dividends and retain some to invest back into the business. Therefore, the balance sheets of most profitable companies will display a retained earnings line.
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.