Finance interview question: Can a company have negative Equity?

 

This week we’re launching a new type of article. We will show you a corporate finance interview question (in Private Equity, Transaction Services, or Investment Banking). Then we will develop the possible answers.

Today we are dealing with a classic accounting question: Can a company have negative Equity?

 

Before we start, what is Equity?

Equity is what is owed by the company to its shareholders.

Often, the easiest way to calculate Equity is to go back to the balance sheet principle (assets = liabilities) and subtract debt from the company’s total assets.

Nevertheless, for your understanding, here are the details of what makes up the Equity:

Share capital: These are the resources contributed by the shareholders in exchange for the company’s shares.

Capital Reserve: These are the accumulated profits from previous years that have not been distributed to the shareholders in the form of dividends that are retained within the company.

Retained earnings: This is an accounting item similar to the previous one. It accumulates the results of previous years not yet allocated between dividends and reserves.

Earnings of the current year.

 

Can Equity be negative?

To answer this question, all we have to do is break down the Equity:

The share capital must be positive or equal to zero. On the other hand, the earnings of the current or previous years can be negative.

Therefore, to the question: “Is it possible to have negative equity” the answer is theoretically yes.

A negative Earning can lower the Equity to the point of making it negative. Nevertheless, in reality, this extreme situation is scarce.

 

Beware of confusion

Above all, distinguish the Equity for shareholders from the Equity Value.

The market value of the Equity: the equity value cannot be negative. Indeed, the equity value corresponds to the number of shares multiplied by the price of a share.

Since both products are positive, it is impossible to have a negative equity value. It is, therefore, essential to distinguish between book value and market value.

 

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