What Does an Increase in Stockholder Equity Indicate?

By Markets Fool.com

Stockholder equity is a key figure on the balance, as it represents the difference between the value of the assets of a company and the value of its liabilities. As companies grow over time, their stockholder equity will often rise, but it's important to understand exactly what contributes to an increase in stockholder equity. Below, we'll look at the two main reasons that stockholder equity can rise.

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The best reason: retained earnings
From an investor's perspective, the most encouraging sign of business success is that it earns a profit. However, not all profitable companies have their stockholder equity go up. What a company chooses to do with its profits will determine whether stockholder equity will rise.

If a company chooses to hold onto its profits and either hold them as cash or use them to invest internally in its business, then stockholder equity will go up. That's because the earnings of the business will cause the value of cash or other assets to rise without any corresponding increase in the company's liabilities. The company's Retained Earnings line item will rise on its balance sheet, and that figure directly feeds into overall stockholder equity.

By contrast, if a company pays out all of its profits to shareholders as dividends, then stockholder equity won't change. The rise in cash from the company's earnings will be offset by the use of that cash to pay dividends, and there will be no net change in retained earnings.

The other reason: raising capital
The other situation in which stockholder equity goes up is when a company obtains additional equity financing by selling stock. The sale of shares increases the amount of cash that the company has, but it doesn't create a new liability. Instead, the proceeds from the stock sale are typically split between the Common Stock line item and the Additional Paid-In Capital on Common Stock line item, according to how much of the proceeds are allocable to the par value of the newly issued shares versus any excess over par value.

In this case, the rise in stockholder equity doesn't necessarily indicate good news for shareholders. Even though total stockholder equity rises, there are a greater number of shares outstanding. If new shares are issued at a discounted value, then existing investors can have the value of their interests diluted despite the increase in stockholder equity.

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Rising stockholder equity is generally seen as favorable, but you have to know why stockholder equity rose. Otherwise, you could draw the wrong conclusions from changes on a company's balance sheet.

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