What is negative equity?
In other words, the business has more financial obligations and debts than the value of its assets. Negative equity can pose significant challenges for a company and may indicate financial distress.
Equity is calculated using the following formula:
Equity = assets − liabilities
If the result is negative, it indicates negative equity.
Several factors can contribute to negative equity, including:
- Accumulated losses: A history of financial losses that reduces retained earnings.
- High debt levels: Excessive borrowing that results in a substantial amount of liabilities.
- Asset depreciation: A decline in the value of assets, particularly if the market value is lower than book value.
Negative equity can have several implications for a business:
- Financial distress: It may signal financial distress, indicating that the company is struggling to cover its financial obligations.
- Reduced borrowing capacity: Lenders may be hesitant to extend credit or loans to a company with negative equity.
- Shareholder concerns: Negative equity is a cause for concern among shareholders, as it degrades the book value of their investment.
Companies with negative equity may implement turnaround strategies to improve their financial position. This may involve cost-cutting, restructuring, debt renegotiation, or other measures to increase profitability and reduce liabilities.
Negative equity can adversely affect how the market perceives a company. Investors and stakeholders may view it as a sign of financial instability, impacting the company’s stock price and credit rating.
Example of negative equity
Company XYZ, a manufacturing firm, has total assets worth £500,000, including equipment, inventory, and cash. However, the company has outstanding liabilities totalling £600,000, including loans, accounts payable, and other debts.
Using the formula for equity:
Equity = £500,000 – £600,000 Equity = -£100,000
In this example, Company XYZ’s equity is negative £100,000. This indicates that the company’s liabilities exceed its assets, resulting in negative equity.