Dividend, Ex-Dividend, Dividend Yield and Related Terms

Definitions, Meaning, and Examples

Dividends are profits distributed directly to shareholders (owners), thereby serving as one means of meeting a profit-making company's primary objective: increase owner value.

Dividends are funds generated by profitable operations that are distributed directly to shareholders, typically just after the end of a financial reporting period.

After a profitable period, a company can (at the discretion of its board of directors) pay some of its income to shareholders as dividends, and keep the remainder asretained earnings. Note that either action (declaring dividends or retaining earnings) meets the textbook definition of a profit-making company's highest objective: increase owner value.

This article defines and explains dividend, with examples, in the context of related dividend payment and dividend investing terms.

Contents

• Declaring and paying dividends 
   − To pay or not to pay dividends?
   − Dividend payment frequency and preferences
   − Paying taxes on dividends
   − The basic dividend metric: Dividend yield
   − Metrics for comparing different dividend investments
     − Dividend payout
     − Dividend growth
     − Company financial metrics for dividend investors
• Reporting and accounting for dividend actions:
• Example Statement of Retained Earnings

Declaring and paying dividends

To pay or not to pay dividends?

When a reporting period ends with a profit, the company can choose to pay some of its income to shareholders, as dividends and keep the remaining income as retained earnings. Dividends are usually paid as cash, although companies occasionally pay dividends as shares of stock or even other kinds of property sent to existing shareholders. 

Companies are not required to issue dividends—they may instead choose to channel all income from a reporting period to a retained earnings account (a balance sheet owner's equity account).

• Between 2005 and 2012, for instance, Apple, Inc. (based in the United States, stock symbol AAPL) did  not pay dividends on its common stock, despite record earnings growth during that period. For the fiscal year ended 24 September 2011, Apple reported a net income of about US $26 billion, of which $0 were declared for dividends.

It is not unusual in fact for "technology" and other "high growth" companies to channel all earnings into balance sheet equity by skipping  dividends. Their Boards presume that the company's stock is still attractive absent dividend payment, and share prices will grow, due to growing book value of the company and the promise of continued earnings growth. On the other hand, companies that prefer to attract shareholders who buy and hold their stock as a steady source of income do pay dividends.

• IBM Corporation, (based in the United States, stock symbol IBM) has paid quarterly dividends regularly since 1967.  For the fiscal year ended 31 December 2011, IBM's reported net income after taxes was about US $15.86 billion. Of this, IBM's Board declared $3.47 billion to be paid as shareholder dividends.

The decision to skip or pay dividends, and how much to pay, is always the responsibility of the Board of Directors, although some Boards may be simply endorsing the recommendations of corporate officers and other senior management.

Note that quarterly or annual corporate financial results are always announced publicly after a reporting period ends—usually several weeks afterwards.  Important dates regarding dividends follow:

• Declaration date: The Board of Directors may announce a decision on dividend payments when financial results are declared, or they may announce dividends shortly afterwards. In any case, the day that dividends are announced is the declaration date.  The Board's declaration on this date creates a legal obligation to pay dividends (which shows up immediately in a "Dividends payable" account, a liability account).
• Date of record: On the declaration date, boards typically also announce a date of record, an ex-dividend date, and  a pay date. Those who are registered with the company as share owners on the date of record will receive dividends. Those not registered as shareholders on the date of record do not receive dividends.
• Ex-dividend date: Closely related to the date of record is the declared ex-dividend date. The ex-dividend date typically comes two or more business days before the date of record. Shares bought on or after the ex-dividend rate do not come with the right to receive dividend payments even though they may be bought slightly before the date of record. That is, those who buy shares on or after the ex-dividend date will not be registered with the company as dividend-receiving owners in time for the immediately forthcoming date of record. 

  The ex-dividend date is the critical dividend-related date for investors because share price normally falls on ex-dividend date by an amount about equal to the per-share dividend.

  The trading day before the ex-dividend date is sometimes called the in-dividend date. Shares traded on the in-dividend date are called in-dividend shares or cum dividend shares, meaning they are "with dividend." 

  Shares traded on or after the ex-dividend date are said to be ex-dividend shares. They are typically priced lower than they were earlier as cum dividend shares.

• Pay date: On the declaration date, boards also announce a pay date for the dividend (also called a payment date, or distribution date). This is the date those who were registered owners on the date of record actually receive payment.

For example, for the fiscal quarter and year ended 31 December 2011, IBM announced financial results. The important dividend related dates for IBM shareholders were:

Financial results announced: 19 January 2012
Declaration date:  31 January 2012
Ex-Dividend date: 8 February 2012
Date of record: 10 February 2012 ( 2 days after ex-dividend date)
Pay date: 10 March 2012

As expected, IBM's share price fell by the end of ex-dividend date, but not by the full value of the declared dividend ($0.75/share), On 7 February (in-dividend date) IBM shares closed at $193.35. A day later (ex-dividend date) IBM shares closed $0.40 lower, at $192.95.

Dividend payment frequency and preferences

Dividend declaration, payment amount, and payment timing are completely at the discretion of the company's board of directors—except for one requirement:  If the board is not willing or able to pay dividends on all shares: they are required to pay dividends on preferred shares before paying dividends on common stock shares. Preferred share dividends, in other words, have preference over common share dividends.

Some companies issue a special class of preferred shares, called Participating dividend shares. "Ordinary" preferred shares may come with a stated dividend to be paid regularly, but participating dividend shares also come with a stipulation that shareholders receive additional dividend funds under certain conditions. That usually means the extra payment is triggered when the common share dividend rises above the stated preferred share dividend.  

In some companies, moreover, preferred shares carry cumulative dividend rights. These rights apply to situations where the Board declares dividends but does not pay them in the current reporting period or before the next dividend declaration date. Once preferred share dividends are declared, the company is legally required  to pay them before paying any common share dividends, even if payment has  have to wait until a future period to pay. Dividends that have been declared but not yet paid are called dividends in arrears.

Dividends may in fact be declared and paid at any time, with any frequency chosen by the company's Board. However, most dividend-paying public companies (companies that sell shares of stock to the public) declare and pay regularly on a quarterly, semi-annual, or annual basis. As of early 2012, for instance, IBM has declared and paid dividends consistently on a quarterly basis since 1967. Ericsson (based in Sweden, stock symbol ERIC) has paid dividends consistently on an annual basis since 2005.

Besides regular period dividend payments, companies may also declare and pay a special dividend at any time. The stock market may in fact expect a special dividend when a company has extraordinary gains (e.g., through a substantial sale of assets), or substantial gains in operating profit. Such expectations can impact stock prices: For instance, as of Late 2011, Wynn Resorts Ltd. (based in the United States, stock symbol WYNN) had declared and paid special dividends in each of the previous 4 years. Expectations of another special dividend in 2011 were credited as the main reason for a 25% increase in Wynn share price during 2011. However, when Wynn announced financial results in October 2011, and made it clear that no special dividend would be forthcoming, the share price dropped immediately.

Paying taxes on dividends

In most countries, shareholders must pay income taxes on dividends received. Many investors view this reality as an unfair form of double taxation. After all, the company itself is a tax-paying entity that has already paid income tax on its earnings before channeling the remaining (after tax) income into dividends or retained earnings.

 In countries such as the United States and Canada, the apparent unfairness is partially—and only partially—mitigated by government regulations that tax individuals for dividend income at a rate lower than tax rates on other income. 

Countries such as France, the United Kingdom, Australia, and New Zealand arguably come closer to avoiding double taxation through the process of imputation.  This is a way of giving shareholders (imputing to shareholders) credit for some or all of the taxes already paid on the income in question. Under imputation, dividend recipients receive imputation credits (or franking credits), and their own tax liability for the dividend income is either lowered or canceled completely (depending on the difference between the corporate tax rate and the individual's own marginal income tax rate, and also on the country's own imputation credit formulas).  

Do investments in stock shares bring a good return on investment? Potential investors begin addressing such questions primarily by examining two sides of stock market investment analysis:

• Expected changes in share prices in the market. 
• The expected timing and magnitudes of future dividend payments.

The two sides to the analysis are interrelated: whether or not a given dividend magnitude qualifies as a "good" return depends on share price, for instance. On the other hand, share price changes in the market depend on several factors, no doubt including expected dividend performance.

The basic dividend metric: Dividend yield

The basic investment metric for evaluating and comparing dividend performances from stocks is a ratio called dividend yield. The concept behind the metric is simple and readily understood: Dividend yield is obtained by dividing a year's total dividends by the share price. That is, the investor's returns (dividends) are compared directly to the cost of the investment (share price). Dividend yield is viewed by some as an instance of the cash flow financial metric return on investment (simple ROI).  

Dividend yield is easy to explain but there is nevertheless room for confusion or misunderstanding with the concept. Consider the dividend yield formula:

Dividend Yield = (Total annual dividends per share) / (Current share price)

"Current share price" in the formula is sometimes called Prevailing share price. The interpretation of the formula is the same with either share price term, "Current" or "Prevailing." 

Dividend yield is usually expressed as a percentage. For IBM's fiscal year ending 31 December 2011, the company paid four quarterly dividends, totaling $3.00 per share for the year. When the final quarter's dividends were declared in February 2012, the IBM share price was about $188. At the time IBM dividends were declared, therefore:

Dividend Yield = $3 / $188
                           = 1.60%

This is the most frequently used dividend yield formula, sometimes more accurately called the formula for current dividend yield. Notice that the dividend total in the formula refers to a complete year's dividend payments, whereas the share price refers to one point in time, that is, the current value. 

Of course, share prices can and usually do change every trading day, bringing a new dividend yield result with every change. It seems almost paradoxical that rising share prices--which increase the owner's potential value in the share investment--at the same time lower the measure of dividend performance. Because dividend yield may fluctuate from day to day and year to year, publishing analysts typically report a company's 5-year average dividend yield in addition to Current dividend yield.

Published dividend data may refer to Trailing dividend yield (or Trailing annual dividend yield), as an indicator that dividend yield is calculated from historical data—dividends paid in the preceding year. Analysts also publish their own estimates of Forward dividend yield (or Forward annual dividend yield), meaning the figure predicts for next year's dividend yield based on the current share price and the analysts predicted future dividend payments. That is, Current dividend yield ( or the equivalent Trailing dividend yield) is history, while Forward dividend yield is a forecast for the future that comes with some uncertainty.

Should dividend yield results be compared directly to ROI estimates for other kinds of potential investments? Some business analysts challenge the notion that dividend yield is truly a return on investment (ROI) metric, comparable to ROI figures from other kinds of investments. Simple return on investment, as applied in business and investment analysis generally, assumes that both the "returns" and the "investment costs" in the ROI formula represent actual cash flows. With dividend yield, however, "share price" in the formula has to be viewed as a hypothetical investor's opportunity cost for holding (for not selling) shares after collecting dividend payments. Opportunity cost is an important and real consideration in investment analysis, but it is not cash flow. That reality may or may not disqualify dividend yield as a true ROI metric, comparable to ROI results from other kinds of investments. Experts take different positions on that issue.  

Other metrics for comparing different dividend investments

Potential investors seeking dividend income have many thousands of dividend-paying stocks to choose from. Naturally they have a keen interest in financial metrics that help compare and evaluate potential stock investments. When professional analysts are concerned especially with dividend performance, the metrics in the following two sections important.  

     Dividend payout

Dividend payout is a measure of the Board's propensity for paying dividends from earned income. As such, the metric is helpful in estimating future dividend payments—if the company's overall financial performance and financial health remain strong (see the section below on Company Financial Metrics for Dividend Investors).  

Dividend payout can be calculated from either of two formulas, both of which give the same result. The first and simplest approach requires (a)  total dividends declared for the period, and (b)  Reported net income for the same period.

[ 1 ]   Dividend payout = Dividends declared / Net income

For example, for fiscal year 2011, IBM's reported net income of about $15.86 billion. For the same fiscal year, IBM's Board declared about $3.47 billion in dividends. From these data:

Dividend payout = $3.47 billion / $15.86 billion
                              =  22%

The other formula for dividend payout uses the company's reported (a) dividends per share, and (b) earnings per share (EPS).

[ 2 ]  Dividend payout = Dividends per share / Earnings per share

For fiscal year 2011, IBM reported earnings per share (EPS) of about $13.08 and total dividends per share of $3.00.  Using these figures in the second dividend payout formula brings the same result:

Dividend payout = $3.00  / $13.08
                               = 22%

Note that published and online EPS reports often use the label EPS (TTM), which indicates that the EPS figure is for the "Trailing twelve months" (preceding twelve months).

Some dividend investors consider a company's recent dividend payout history as an indicator of future dividend performance. Many prefer stocks with a consistent but relatively low dividend payout (less than 25%).  A low payout now leaves room for dividend payout growth in the future.

     Dividend growth

For many dividend-paying companies, year-to-year dividend growth is regular and/or somewhat predictable. Trends in Dividend growth—like the two dividend metrics above—are good indicators of a company's future dividend payments if the financial performance and financial health are strong (see Company Financial Metrics for Dividend Investors below). 

Dividend growth is usually measured as an average rate at which dividend payments change, year to year. 

One year's dividend growth is simply:

1-Yr dividend growth = ( A - B) / B

Expressed as a percentage, where
A = Most recent year's total dividend per share
B = Previous year's total dividends paid per share

Exhibit 1, below, shows dividend growth information in graphical form.

Exhibit 1. IBM Dividends paid and annual dividend growth rates, 2000 - 2011. For the last 5 years of this period, annual dividends per share have grown at an average rate of 20.4%. This information will be useful for investors, for deciding whether to buy, hold, or sell IBM shares, or to invest in other dividend-paying stocks instead.

Company financial metrics for dividend investors

Dividends are declared and paid from earnings—net income after taxes. Dividends are declared and paid, moreover, by boards of directors concerned first with the company's long term survival and growth. As long as the company's financial performance and financial health are strong, generous dividend payouts may support their objectives for the company's capital structure. On the other hand, boards may reduce or skip dividends when performance and health need improvement, as signaled by poor earnings growth, a debt/equity balance that needs adjustment, inadequate working capital, or other warning signs. As a consequence, dividend investors will also pay close attention to traditional company financial metrics (or financial ratios) and their growth rates, such as 

• Net income
• Earnings per share
• Return on equity
• Price to earnings ratio (P/E ratio)
• Debt to equity ratio
• Working Capital

Reporting and accounting for dividend Actions: Example Statement of Retained Earnings

For a profit making public company, the Board of Directors designates how income is distributed after each reporting period and this distribution is reported through the Statement of Retained Earnings. This statement shows how Income Statement profits from the period are either transferred to the balance sheet, as retained earnings, or to stockholders as dividends. The Statement of Retained Earnings thus serves as a bridge, or connecting link, between Balance Sheet and Income Statement.

The basic Statement of Retained Earnings equation is as follows:

Net income = Preferred stock dividends paid
                            + Common stock dividends paid
                                + Retained earnings

and, equivalently

Retained earnings = Net income
                                       – Preferred stock dividends paid
                                             – Common stock dividends paid

Retained earnings, in other words, are the funds remaining from net income after dividends have been paid to the owners (shareholders).  Note that dividend payments are not considered expenses and do not appear on the Income Statement. Dividend payments are not expenses because they are taken from net income, after all expenses have been subtracted from revenues.

Each period's retained earnings are added to the cumulative total
from previous periods, to create the current retained earnings balance.

This example Statement of Retained Earnings is from the same set of related company reporting statements used elsewhere in this encyclopedia, including an example Income Statement, Balance Sheet and Statement of Changes in Financial Position.

(source)

Statement of Retained Earnings

Definition, Meaning, Structure, Content, and Example

The statement of retained earnings shows how a period's profits are divided between divi-

dends for shareholders and retained earnings, which are kept to accum-

ulate under owners equity on the balance sheet.

Retained earnings are the part of a company’s income kept to accumulate, after dividends are paid. The company’s accumulated retained earnings appear on the Balance Sheet under owner’s equity. Retained earnings are declared each year on a statement of retained earnings. After a profitable period, a company can (at the discretion of its board of directors) pay some of its income to shareholders, as dividends, and keep the remainder as retained earnings.

The statement of retained earnings is one of the four primary financial accounting reports published quarterly and annually by publicly held companies (companies that sell shares of stock to the public). The other three are the income statement, balance sheet, and statement of changes in financial position (SCFP).  

For purposes of financial accounting, a profit making company can do only two things with profit earned: (1) distribute to shareholders (the company owners) as dividends or (2) keep some or all of the profits as retained earnings. Many companies divide profits for both uses each year.

The  statement of retained earnings is sometimes described as a bridge between the Income statement and balance sheet. The statement shows how profits from the period (from the Income statement) are either transferred to the balance sheet, as retained earnings, or to the company's owners (shareholders) as dividends.  

The basic statement of retained earnings equation is as follows:

              Net income   = Preferred stock dividends paid
                                        + Common stock dividends paid
                                        + Retained earnings      
      
 and, equivalently     
      
 Retained earnings   = Net income
                                      – Preferred stock dividends paid
                                      – Common stock dividends paid      
      
Retained earnings, in other words, are the funds remaining from net income after dividends have been  paid to the owners (shareholders). Each period's retained earnings are added to the cumulative total from previous periods, to create the current retained earnings balance.

Contents

•  Example statement of retained earnings
•  Retained earnings interface with other financial statements

Example statement of retained earnings

This example statement of retained earnings is from the same set of related company reporting statements used elsewhere in this encyclopedia, including an example income statement, balance sheet and statement of changes in financial position.

Retained earnings interface with other financial statements

The Statement of retained earnings is the shortest of the four primary financial accounting statements, but it provides the clearest illustration of the interrelated nature of these statements. Every entry in the example above also appears on another of the primary statements.

• The retained earnings beginning balance appears on the previous period's (end of period) balance sheet, under Owner's Equity.
• The net income figure is of course the bottom line, or net profit figure from the current period's income statement
• The dividend payments for preferred and common stock shareholders also appear on the current period's statement of changes in financial position, under Uses of Cash.
• The end of period retained earnings balance also appears on the current balance sheet under Owner's Equity.

Equity: Owner's Equity, Net Worth, and Book Value

Definitions, Meaning, and Examples

Owners equity is the book value of company assets owned outright by shareholders. On the balance sheet, owners equity includes contributed capital and retained earnings. Increasing owner value is often cited as the highest level objective for profit-making companies

Owner's equity (or owners equity, or stockholder's equity, net worth, or book value of a company) is the ownership interest of shareholders in the assets of a corporation. Owner's equity, that is, represents what the owners own outright. 

Business textbooks often describe the highest level objective for a profit-making company as "Increasing owner value." In this sense, owner's equity represents a company's reason for being. 

Owner's equity is one of the three main sections of the so-called accounting equation, or balance sheet equation. When companies publish a balance sheet after a reporting period ends, the following equality must hold:

Assets = Liabilities + Owner's equity

The total Balance Sheet Assets value represents the "book value" of everything the company has to work with, for earning money. Owner's equity is the portion of that value that the owners (shareholders) presently own. If owner's equity is subtracted from Asset value, the remainder represents Liabilities, monies owed by the company to lenders, bond holders, and other creditors. 

Owner's equity, in turn has two components: Contributed capital + Retained earnings. As shown in the balance Sheet example below, these components are:

• Contributed capital, which includes funds paid by investors for the purchase of stock directly from the company. This occurs at the company's initial public offering (IPO), and when the company issues more shares again at subsequent stock offerings (Stock shares purchased in the secondary market do not contribute to contributed capital). See the encyclopedia entry on contributed capital for more on the components of this category.
• Retained earnings are profits the company has earned and used to grow equity. The other main use for profits that a company may choose (instead of adding them to retained earnings) is to distribute profits directly to shareholders as dividends.

See the section Increasing and Decreasing owner's equity, below, for more on these components.

The owner's equity concept applies to companies in business, but the idea is comparable to the idea in personal finance, where a homeowner speaks of "equity" in the home property. In that case, Equity represents the initial down payment on the property plus the part of the mortgage loan principal that has been "paid off."

Contents

• The importance of owner's equity (Net worth)
   - Owner's equity in liquidation
   - Owner's equity in financial leverage
      - Total debt to equities ratio
      - Long term debt to equities ratio
      - Rules of thumb for debt to equities ratios
• Increasing or decreasing owner's equity (Net worth)
   - Increasing owner's equity through contributed capital
   - Increasing owner's equity through retained earnings
   - Decreasing owner's equity   
• Balance Sheet example with owner's equity (Net worth)
• Example statement of retained earnings 

The importance of owner's equity (Net worth)

In the Balance Sheet example below, for instance, a company's Balance Sheet assets are reported as $22,075,000 and its liabilities as $8,938,000, while owner's equity is the difference between these two numbers, $13,137,000.

The relationship between Liabilities, Assets, and owner's equity (Net Worth, Book Value of the Company) becomes especially important to owners and potential investors in at least two situations.

1. When the company goes out of business and into liquidation.
2. When the company chooses a capital structure including a degree of financial leverage.

Owner's equity in liquidation

When a company decides to go out of business and goes into liquidation, its assets are sold (liquidated) and the proceeds are used first to pay off outstanding liabilities and creditors (including bondholders), and to pay taxes and liquidation expenses (including legal fees and legal judgements). Only then can any remaining funds be distributed to others with an "equity claim."  

Those remaining with an equity claim may include owners of preferred shares, owners of common stock shares, and even the company's managers, employees and pension holders in some cases. The precise order of preference and the rules for distributing the remaining funds to these groups may be specified ahead of time in several different ways and may or may not include provisions for paying dividends due to shareholders. Those whose claims come last in the order of precedence for receiving payment on equity claims are said to have a residual claim (this designation usually applies to owners of common stock shares).

The order and rules for equity distribution under liquidation may be spelled out when stock shares are created and first issued, and/or in the original company articles of incorporation.

With the above process in view, it is understandable why the company's creditors and the company's shareholders have a very keen interest in the relative magnitudes of the company's liabilities compared to owners equities. Shareholders may fear that the liability claims may consume all or most of the funds raised through liquidation, leaving little or nothing for them. At the same time, if liabilities are large relative to owner's equity, creditors may fear that proceeds from asset liquidation will not even be large enough to pay off all creditors.  

Investors and potential investors should note that actual funds raised through sale of the company's assets in liquidation may be either substantially more or substantially less than the Balance Sheet "book value" for these assets. Balance sheet book value for assets is not necessarily the same or even close to assets actual market value or realizable value.

Also, investors and potential investors should remember that in most countries a company may declare bankruptcy, but not intend to go out of business. In such cases, the company does not liquidate, but instead "reorganizes" while receiving legal protection from its creditors, re-negotiating or discarding labor contracts and other contracts, and perhaps selling off parts of the business. In this kind of bankruptcy, the fate of existing shareholder value and shareholder equity claims is much less prescribed and much less certain.  In the United States, this kind of bankruptcy process is known as a Chapter 11 bankruptcy filing (referring to its Chapter in the United States Bankruptcy Code). 

Owner's equity and financial leverage

Risks of a corporate enterprise are borne both by creditors and owners,  in proportion to their share of the company's funding. The relative magnitudes of creditor supplied funds (included in Balance Sheet Liabilities) compared to investor supplied funds (owner's equity) is called financial leverage.

In a strong economy or when the business is otherwise doing well, owners may make more on creditor supplied funds than they pay for the cost of borrowing, illustrating a benefit of using leverage. However, the reverse can be true in a poor economy or if the company starts performing poorly for other reasons: in those cases, earnings may not be high enough to justify the cost of funding (interest payments on the borrowed funds), and the borrowing costs fall especially heavily upon the owners, illustrating one of the risks of using leverage.

When the majority of a company's funding is provided by creditors (compared to funding provided by owners), the company is said to be highly leveraged.

• If a highly leveraged company fails and defaults on loans, creditors will lose much more than owners.
• When business is good for a highly leveraged company, it should be able to service its debt, and owners (shareholders) can look forward to relatively large gains on their relatively small investments. Gains will go to owners either as dividends or as retained earnings, which increase owner's equity.

Several financial leverage metrics compare the funds supplied to a company by creditors to the funds supplied by the company's owners. Two of the most commonly used leverage metrics are shown here: (1) The total debt to equities ratio, and (2) the long term debt to equities ratio. For more coverage of leverage and leverage metrics, see the encyclopedia entry leverage.

The leverage metrics examples here use data from the sample Balance Sheet, also included below.

     Total debt to equities ratio

The first of these debt to equity ratios, total debt to stockholders' equities, is the strongest of these measures, that is, it provides the most conservative view of creditor protection. This ratio compares two Balance Sheet entries, Total Liabilities and Total owners Equities (stockholder's equities). For this example calculation, figures are taken from the sample Balance Sheet below:

     Total liabilities: $8,938,000
     Total stockholders equities: $13,137,000

Total debt to equities ratio
     = Total liabilities / Total stockholders equities
     = $8,938,000 / $13,137,000
     = 0.680

      Long term debt to equities ratio

Another debt to equities ratio, long term debt to stockholders equities, is less conservative than the previous ratio but more properly a measure of leverage, because the debt figure contains only debt to lenders, or long term debt, (as opposed to total debt, which includes debt to vendors, employees, and tax authorities as well as debt to lenders).  Using figures from the Balance Sheet example below: 

Total long term liabilities: $5,474,000
Total stockholder's equities: $13,137,000

Total debt to equities ratio
     = Total long term liabilities / Total stockholders equities
     = $5,474,000 / $13,137,000
     = 0.417

     Rules of thumb for debt to equities ratios

Average debt to equities ratios vary widely between industries, and between companies within industries. Even so, it is possible to present some general "rules of thumb" for evaluating a company's ratios:

• Potential lenders will compare a company's debt to equities ratios to industry standards. If the company's ratios are substantially different from industry standards, lenders will need extra assurance that the departure from standards does not represent increased risk--especially debt service risk.
• Potential Investors, but will also consider carefully the sources of the existing debt as well, along with the company's prospects for repayment. In other words, potential investors will consider the risks associated with existing individual debts, such as varying loan service costs with different loans. They will view these costs as an important factor in addition to the debt to equity ratios themselves.
• With the above in mind, potential lenders generally consider a total debt to equities ratio of 0.40 or lower as "good," and a long term debt to equities ratio of 0.30 or lower as good. As the company's debt to equities ratios rise above these values, loans become more difficult to acquire.

Increasing or decreasing owner's equity (Net worth)

As mentioned, owner's equity can be thought of as a company's reason for being because it represents the often-stated top-level objective for companies in private industry: Increase owner value. There are only a few ways that owner's equity can be increased or decrease.

Under a double entry bookkeeping/accounting system, as used by the vast majority of businesses, Equity balances are carried in equity accounts. Normal equity accounts carry a Credit balance and are increased by credit transactions. The same is true of normal liabilities accounts and revenues accounts. The balance in these accounts is decreased by Debit transactions.

By contrast, accounts classified as expense accounts or asset accounts carry a Debit balance, are increased by debit transactions, and are decreased by Credit transactions.

Increasing owner's equity through contributed capital 

Paid in capital (also called contributed capital) is a Balance Sheet account, showing what has been invested by stockholders through purchase of stock from the corporation (not through purchase of stock on the open market from other stockholders). When investors buy shares directly from the company, that is, the company receives and keeps the funds as contributed capital (paid in capital). When shares are bought on the open market, however, funds go to the investor selling them.

Contributed (paid in capital) capital is one of the two main owner's equity categories on the Balance Sheet. The other is retained earnings. Contributed capital, in turn, has two main components:

• Stated capital, which is usually defined as the stated, or par value of the shares of stock that have been issued ( the stated capital is listed on the Balance Sheet below is the cum of values listed for as "Preferred stock" and "Common stock.").

• Additional paid-in capital, capital contributed in excess of par  represents money paid to the company above the par value.

Contributed capital in both categories can thus flow company and add to owner's equity at the company's initial public stock offering (IPO), and again later as additional stock is issued (For more on the difference between par value and capital contributed in excess of par, see the encyclopedia entry par value).

Increasing owner's equity through retained earnings

Whereas contributed capital does add to owner's equity, company owners will hold management responsible for adding to owner's equity primarily by earning profits and then using profits to grow retained earnings. 

For purposes of financial accounting, a profit making company can do only two things with profit earned: (1) distribute to shareholders (the company owners) as dividends or (2) keep some or all of the profits as retained earnings. Many companies divide profits for both uses each year.

The disposition of earnings (profits) for each reporting period is published on the company's Statement of Retained Earnings, one of the four primary financial accounting reports published quarterly and annually by publicly held companies.(The other three are the Income Statement, Balance Sheet, and Statement of Changes in Financial Position (SCFP).

The Statement of Retained Earnings is viewed as a bridge between the Income Statement and Balance Sheet. The statement shows how profits from the period (from the Income Statement) are either transferred to the Balance Sheet, as retained earnings, or to stockholders as dividends.

The basic Statement of Retained Earnings equation is as follows:

Net income
     = Preferred stock dividends paid
     + Common stock dividends paid
     + Retained earnings

This equation can be solved for retained earnings:

Retained earnings
     = Net income
     – Preferred stock dividends paid
     – Common stock dividends paid

Retained earnings, in other words, are the funds remaining from net income after dividends have been paid to the owners (shareholders). Each period's retained earnings are added to the cumulative total from previous periods, to create the current retained earnings balance.

In the example Statement of Retained Earnings below, retained earnings at the end of the previous reporting period and beginning of the present period stood at $2,660,000 (this figure would come from the previous year's Balance Sheet, under owner's equity). For the period, the company earned (reported net profits on its income statement of) $2,172,000. If the company were to pay no dividends, retained earnings would now be the sum of these two figures, $4,832,000. The company did elect to pay dividends totaling $1,134,000, however, leaving retained earnings at the end of the period at $3,698,000.

The company has, in other words, increased owner value this period both by paying dividends and by growing retained earnings (thus growing owner's equity).

It should be mentioned that the above example refers to cash dividends. Companies may also issue stock dividends to shareholders, in which case owner's equity decreases, but paid in capital increases by an equal amount, thus having no overall impact on owner's equity.

Decreasing owner's equity.

In small, privately held companies it is not unusual for the owner (or owners) to withdraw funds from the company from time to time by using a withdrawal account to take funds directly from an owner's equity account. Such an account is an equity contra account, sometimes called a drawing account.  This reduces owner's equity. Such withdrawals and reductions to owner's equity are much rarer in public companies with large numbers of shareholders. 

The more usual means of reducing owner's equity is the payment of expenses. In fact, the general definition of "expense" refers to its impact on owner's equity: Expense is defined as a decrease in owner's equity caused by the using up of assets in producing revenue or carrying out other activities that are part of the entity’s operations.

Balance Sheet example with owner's equity (Net worth)

Owner's equity is one of the three main sections of the Balance Sheet, as shown in the example below. Note, however, that many corporations will identify owner's equity as Stockholder's Equity for the Balance Sheet.

The other two main sections are Assets and Liabilities.

Example Statement of Retained Earnings

Retained earnings figures for the examples above were taken from the example Statement of Retained Earnings below.

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Balance Sheet B/S (Statement of Financial Position)

Definitions, Meaning, and Examples

On the balance sheet Assets always equal the sum of Liabilities plus Owners Equities. Financial position is shown by comparing balance sheet categories with each other (as with Working Capital), or with income statement categories (as with Return on Assets)

The balance sheet (B/S, or statement of financial position) is one of the four primary financial reports (financial accounting statements) that publicly held companies must file every quarter and year. The other three are the income statement, the statement of retained earnings, and the cash flow statement (or statement of changes in financial position, or financial cash flow statement). Balance sheets for government and non profit organizations are also published periodically, often called "Statement of Financial Position."

For a specific point in time, the B/S reports:

•  What an entity owns outright (equities).
•  What the entity owes (liabilities).
•  The resources the entity has to work with (assets).

More accurately, the balance sheet reports the end of periodbalances in the entity's asset, liability, and equity accounts. The balance sheet is normally prepared and published as one of the final closing events for an accounting period, after all the period's transactions are posted to general ledger accounts, after a trial balance period in which accountants search for and correct transaction and posting errors.

In principle, a company or organization could publish a new and different version of the balance sheet every day, but they normally do so at the end of fiscal quarters and years. The B/S heading identifies the time point with a phrase such as this: "...at 31 December 2013." The B/S is thus a "snapshot" of the etntity's financial position at one time point, whereas the income statement and statement of changes summarize financial activitiy for a specific period of time (quarter or year).

The balance sheet’s 3 main sections represent the so-called accounting equation:

Assets = Liabilities + Owners equity

The term balance means that the sum of the entity's assets must equal (balance) the sum of its liabilities and owner’s equities. This balance holds, always, regardless of whether the company's financial position is good, or terrible. Principles of double entry bookkeeping and accounting ensure that every transaction that impacts the total on one "side" of the B/S brings an equal, offsetting change in the total for the other "side."

Analysts evaluate the "health" of the company's financial position not by the overall magnitude of the Assets number, or its balancing counterparts, but rather by therelationships between numbers on the sheet. (See the section on B/S contributions to financial statement metrics and ratios, below.)

Contents

•  Balance sheet: simple example and main categories
•  Keeping the balance: debits and credits
•  Detailed report example
•  B/S contributions to financial statement metrics and ratios

Balance sheet: Simple example and main categories 

This sheet example shows the major categories usually reported under assets, liabilities, and equities.

The entire sheet is sometimes presented in horizontal layout, with an Assets Page on the left, and a page for Liabilities and Equities on the Right. Alternatively, it can be presented in vertical format (as above), with the Assets Section above the Liabilities and Equities sections that, together, balance it.

The main categories shown above are defined after the more detailed example below.

Keeping the balance: debits and credits

Many people readily understand the structure and mathematics of the income statement, but have trouble understanding the balance sheet. One reason for this, probably, is that the income statement simply starts with revenues, and then subtracts expense items to reach a bottom line net profit, in much the same way that individuals manage a personal checkbook register. However, understanding B/S dynamics requires an understanding of a few basic principles of double entry bookkeeping and accounting.

Those familiar with accounting systems may also note that most of the balance sheet line items are really the names of accounts from the organization's Chart of Accounts, specifically, the "Assets," "Liability," and "Equity" category accounts. (For more on building the balance from accounts and account balances, see the encyclopedia entryTrial balance.)

Both the income statement and the balance sheet start with simple equations. For the income statement, this is:

Income = All Revenues – All expenses and costs

The balance sheet starts with an equally simple equation, the accounting Equation:

Assets = Liabilities + Owners Equity

Regarding the balance sheet and double entry bookkeeping, it is sometimes said that the Accounting Equation above must be extended to include this component:

Debits = Credits

In normal usage, people think of debits to, for example, their checking accounts, simply as subtractions, and credits to the checking account simply as additions. Banks in fact use this terminology on statements to account holders. To accountants, the bank's usage is technically correct, but this is only because the bank regards an account holder's account as a liability account for the bank.  In double entry bookkeeping, for accounts on the "Liabilities and Equities" side of the sheet:

• Increasing the value of a liability, equity, or so-called revenue account is a credit.
• Decreasing the value of a liability, equity, or revenue account is a debit.

On the other side of the balance sheet—the "Assets" side—the rules for debits and credits are reversed:

• Increasing the value of an asset or an expense account is called a debit.
• Decreasing the value of an asset or an expense account is called a  credit.

In double entry bookkeeping and accounting, every transaction must impact at least two accounts. Whether the impact is called a "debit" or a "credit," depends on the kind of account involved, as described above.

Suppose the company acquires assets valued at $1,000. An asset account (perhaps under Current Assets) increases $1,000—considered a debit transaction because the account is on the asset side of the sheet. The sheet is now temporarily out of balance, until a second transaction is made, a credit transaction of the same size. This could be either

• A corresponding reduction in another account on the Asset side of the sheet, e.g., a credit (i.e. reduction ) to a cash account also under Current assets, or a credit to an Expense account (which will be transferred to the Asset side of the sheet)
• A corresponding increase in an account on the Liabilities and Equities side. For example, an increase (credit) of $1,000 to a long term liabilities account if the purchase funds were borrowed.

In this way, balance sheet assets will always equal liabilities plus equities and debits will always equal credits.

Detailed report example

A more detailed version of the example statement from above is presented here. Definitions for the major categories and line items appear below the example.

On the Assets side, the major categories usually include:

Current assets: These are assets that, in principle, could be turned into cash in a relatively short time. "Short time" is generally understood to be one year or less. Current assets includes, of course Cash on hand, but also Short term investments, Accounts receivable, Inventories, and Prepaid expenses.

Long term investments and funds: These are assets that are not so easily turned into cash quickly, which include ownership of stocks and bonds in other companies, as well as other long term (over one year) investments.

Property, plant & equipment: These are the company's major physical assets, including such things as buildings, factory machines, vehicles, and large computer systems. The cost of these assets is normally charged against income as depreciation expense across the depreciable life of the asset. Note that each year of the asset's depreciable life, the depreciation expense contributes to accumulated depreciation, reducing the "book value" of the TOTAL assetS.

Intangible assets: Assets which cannot be seen or touched, but which arguably are (a) owned by the company, which has exclusive rights to them, and (b) contribute to earning ability. These may include copyrights and patents, trademarks, brand image, and goodwill.

On the Liabilities and Equities side, the major categories usually include:

Current liabilities: These are generally described as the obligations the company has that must be met within a short time, such as one year or less. They may include such things as accounts payable, the current portion of long term debt that is due, and estimated short term warranty obligations.

Long term liabilities:  These are obligations that are not due immediately, but due instead for a period longer than one year. Long term liabilities may include bank notes payable, bonds payable, or long term financing arrangements for purchases.

Contributed capital: One of the two main categories under Owner’s equity (the other is Retained earnings). Contributed capital shows what has been invested by stockholder’s through purchase of stock from the corporation (not through purchase of stock on the open market from other stockholders). Contributed capital, in turn, has two main components: Stated capital, which represents the stated, or par value of the shares, andAdditional paid-in capital, which represents money paid to the company above the par value.

Retained earnings: The part of a company’s income kept to accumulate, afterdividends are paid. The company’s accumulated retained earnings appear on theBalance Sheet under Owner’s Equity .After a profitable period, a company can (at the discretion of its board of directors) pay some of its income to shareholders, as dividends, and keep the remainder as retained earnings.

B/S contributions to financial statement metrics and ratios

The balance sheet is a primary source for input into financial metrics and financial statement ratios that address questions like these:

What are the company's prospects for future earnings?
Valuatio metrics such as the price to earnings ration deal with such questions.

Is the company prepared to meet its short term financial obligations?
 Liquidity metrics such as current ratio address questions of that kind.

Is the company using its resources efficiently?    
 Activity metrics such as inventory turns are designed for such questions.

Are the company's funds supplied primarily by owners or by creditors?   
Leverage metrics, such as debt to asset ratio provide answers

Is the company profitable? Is it making good use of its assets?    
Profitability metrics such as operating margin address such questions.

How does the company's growth over the last five years compare to similar companies? To industry averages? Growth metrics such as the cumulative average growth rate CAGR for Sales revenues address such questions.

  Financial statement metrics are generally used by… 

• Investors considering buying or selling stock or bonds in a company. 
• Company management, for identifying strengths, weaknesses, and  target levels for business objectives. 
• Shareholders and boards of directors, for evaluating senior management.

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