N
egative shareholder equity could show up on a company’s balance sheet for a number of reasons, all of which should serve as red flags to look much closer before investing. To understand why, you need to look no further than the formula for shareholder equity:
Total Assets – Total Liabilities = Shareholder Equity
As a measure, shareholder equity reveals what the owners of a company (stockholders) would be left with if all assets were sold and all debts were paid. In the case of negative shareholder equity, the owners theoretically would owe money, although the structure of publicly traded corporations prevents common stockholders from facing actual liability.
Negative shareholder equity most often comes from the accounting methods used to deal with accumulated losses from prior years. These losses generally are viewed as liabilities carried forward until future cancellation. Oftentimes, the losses exist on paper only, which makes it possible for a company to maintain operations, despite the continued posting of substantial losses.
Other situations that can contribute to negative shareholder equity are leveraged buyouts (or borrowing), severe depreciation in currency positions and substantial adjustments to intangible property (patents, copyrights, goodwill and the like).
For more on this topic, read Breaking Down the Balance Sheet.
This question was answered by Ken Clark.