Negative shareholder equity--at least from a securities perspective--is not a problem in and of itself generally in the U.S. It can result from any number of corporate histories. Corporate valuations tend to vary widely from their shareholder equities. I am not aware of any state's corporate law that considers it a problem, in and of itself, either. In Delaware, the measure that matters is "surplus," which is drawn from a corporation's market value rather than its book value. Delaware corporations, for example, can pay dividends, borrow money, issue new securities to investors, etc. notwithstanding a negative s/h equity, so long as they have adequate "surplus" meet minimum capital and other legal requirements. I would say s/h equity, while important, is seen more as an accounting function that can-but does not always-track the actual value of a company. The only time I have ever seen it come up as a legal matter is in the case of one company that wanted to self-insure itself for workers compensation liabilities. The state denied the company's application to self-insure on the basis of negative shareholder equity--notwithstanding its market capitalization was in the hundreds of millions. It was just a requirement buried in the state's regulations that used s/h equity as its measure of a corporations value (and, thus, its ability to pay worker's comp claims).

Look at Revlon. Here is a firm with about 1.2 bil in assets and 1.9 bil in debt, giving it negative equity of 0.7 bil. This is less than it was a few years ago, when its equity was about negative 1 billion. Yet it survives, and is an NYSE firm. It seems as if this can go on fo a long time, and is permissable by the state and indeed the NYSE. And at times Revlon a recommended stock. Why? Could it be that the value of the Revlon name is not captured in the assets.

Your example is very good because it shows that a change in stockholders' equity can be a good measure of performance. Revlon's increase in s/h equity shows that it is performing well, even though it is negative (and will probably be for years to come). Although, like book value, there are plenty of other reasons s/h equity change absent a valuation change. A general example is companies that have (from prior years) built a huge bank of net operating losses (NOLs), which can shield a company from tax liability for a long time. These NOLs, while having value cannot be booked as assets unless the company is showing, according to accounting standards, that it will actually use them. Once a company that has been losing money (and accumulating NOLs as well as, likely, shareholder deficit) becomes consistently profitable, these NOLs can be booked as an asset. The asset is the value of future tax savings. That can turn a company's negative book value into a positive book value overnight--even though the company's market value hasn't changed at all. This can also happen the other way. I recall this happening to Ford around the time of the financial crisis. They booked a massive loss in one quarter largely on the basis of the elimination from their balance sheet a tax asset based on the value of their NOLs. It was a bad quarter for them to be sure (like everyone else), but the accounting loss magnified it several times in a way that didn't track performance. Ford, after all, was the only major car company in the U.S. that avoided bankruptcy during the crisis.

As long as the company's cash flow is adequate to meet its bills, it can continue operating indefinitely, regardless of what its shareholder equity is. Inversely, if cash flow is inadequate, it will wind up in bankruptcy court even if on paper it has high shareholder equity. Shareholder equity is an accounting measure with at times a limited relationship with reality.

It may be of interest to note that there's an additional consideration for Banks: they can become insolvent if losses on assets (loans) exceed "Tier 1 capital" which includes common stock and retained earnings. So not the same as shareholder equity, but both would be affected by losses, just that the consequences are more severe when capital adequacy rules are breached.

Interesting. Is there a difference in Tier 1 capital in that it is somehow marked to market value, whereas s/h equity is based on historical values? Or is Tier 1 capital measured the same way as s/h equity, except that it measures the more narrow category of tier 1 equity?

Good point, Paul. I should have noted that my earlier answer does not apply to banks, which are regulated and can be forced out of business for failure to meet Tier 1 capital requirements even if in real (as opposed to accounting) terms they are fully solvent.

Thanks Douglas, I think that addresses my question.

ok, and what about shareholders´ and investors´ concerns? How does negative shareholder equity affect shareholders and investors? Do investors in those companies? Will shareholders receive any dividdends?

Equity is one source of finance the company run, in other source of investments . In practically that is the gap of accounting concepts, theories, standard and norms, It is time to introduce new tools to evaluate business We have to think creative accounting and business decision mechanism.

On the other hand auditing and audit procedures are not match with the real business life.

Shareholders can receive dividends from companies (at least in the U.S.) even though they have negative shareholder equity. Investors invest in these companies all the time. Shareholder equity (or deficit), as I attempted to note above, is a "book value" value of a company that is drawn solely from its accounting history. Investors are expected to understand, I believe, at least that much. How to value a company is, of course, an entirely different matter. Llittle of valuation, in my experience, has to do with the book value of the company--except to the extent that it happens to reflect correctly the underlying fundamentals of the company, its performance, and its future prospects. A basic way to think about it might be that book value is backward looking and reflects past results using generally accepted accounting methods. Company valuation is more forward looking, and, thus, could vary substantially from past performance. Company valuation can be done in innumerable ways. One might be tempted to simply look at the company's value in the public markets--although I would not suggest that is a generally accepted method by many experienced investors. One, indeed, when investing, does so by concluding that a company in undervalued by the market, after all.

There is a lot written in the 1980's about "zombie" savings and loans. These financial institutions should have been closed but was not enough money to write the check. They were finally closed in the late 1980's but before then were allowed to continue business as usual. More recently, we still have too big to fail.

I have found that the discourse between Timothy Watts and Douglas Friedman very interesting and enlightening . I have little difference of view with Douglas's point that' " -Inversely, if cash flow is inadequate, it will wind up in bankruptcy court even if on paper it has high shareholder equity.'" Yes, I do agree that is a possibility . But, as famous economist James Tobin pointed out those asset may be purchased by some others and they might be able to generate future profitable cash flows. by better utilizing assets. Therefore, the point is that asset valuation does not necessarily depend on the present cash flows and it is also the discounted present value of the future cash flows!

I agree with the paul. I will say that company's negative earnings will have no bearings on the decision of investor as long as the investor feels that company have positive prospects and in the given economic scenario it can have positive earnings.

Bank accounting has to be treated somewhat differently to standard company accounting as there are some other things going on. The cash flow element is similar, as long as a bank is receiving sufficient income to cover its expenses, and it is not forced to write down its debt, then it can continue somewhat indefinitely. The critical thing with non-performing loans though, is that they also represent new lending (resulting from capital repayment) that isn't occurring, so there are systemic implications for the credit supply, and possibly for the money supply as well. This creates the zombie bank phenomena.

Because capital is used as a regulatory mechanism in Basel, it can't have varying value, so the shareholder equity component of Tier 1 is accounted as a fixed value - it actually represents the asset money that was ponied up to fund the bank (as opposed to the liability money (deposits)), the bank generates in the course of doing business.

When loan losses have to be recognised, and cannot be covered from loss provisions and profits, then they're deducted from capital. Because the regulatory relationship is that banks lend a multiple of their risk weighted capital (subject also to any reserve requirements), the result of capital write-downs for any significantly sized bank is an economy wide credit contraction as the credit and money supply are forced to shrink, by what is fundamentally a mathematical phenomena, rather than necessarily an economic one.

There isn't really a disagreement with what M. Thomas Paul wrote and what I wrote. It is true that any worthwhile assets will be acquired in a bankruptcy proceeding (and at a low enough price, almost any asset is worth buying), but that doesn't change the fact that the initial company will still have gone bankrupt, which is what the initial question asked about.

It can survive as long as it can survive its commitments.

I am guessing as long as their cash flows can pay for operations and liabilities...that is , as long as they can access liquidity

ok, but negative shareholder equity means that there are more total liabilities than total assets. We should also take into consideration interests that increase debts (liabilities). Therefore there is not enough assets to pay all commitments.

Economic analysis has an unfortunate tendency to ignore units, and this is one of those times when it matters. Debt is formally a commitment to make a stream of payments over time, it is not the same thing as the absolute value of a material asset - say a building or plant machinery. While strictly at any given instantaneous point, the absolute value of assets may well be less than the absolute value(outstanding capital) of the debt, as long as the company has sufficient income over time to meet the debt repayments, then it can continue as Umair pointed out. This is also the point Michael Kalecki was making with his infamous 'Economics is the science of mistaking a stock for a flow' comment.

Negative equity also reflects aggressive financing strategies by the firms. This could possibly due to market opportunities for growth, and we should not forget the risk appetite of investors. With other factors such as organizational capacities including innovation and organizational learning, these kind of firms are continuously supported by the market. The issue is how to encapsulate all these significant factors into one model.

Negative equity or capital is seriously treated in the banks and financial institutions. Once the capital is eroded, which could be due to high operating costs, non performing loans, banks are subject to regulatory restrictions. However, since there is a large number of depositors involved, regulatory authorities try their best to reform the financial institutions by taking over the management or by detailing the financial sector reform programs with support from the international financial institutions, like World Bank and the International Monetary Fund. Having capital strong is an indicator for the viability of the banks and financial institutions.

In response to Michal's latest comment, it may be true that in accounting terms there are insufficient assets to pay off creditors, but that is not necessarily a problem, nor is it even necessarily true in real terms. Imagine a company owes $30 million and its only asset is a building it bought 20 years ago. The book value of the building, post-depreciation, may be zero. In reality, that building may be worth well more than $30 million, so assets are more than sufficient to match obligations.

In any event, as Timothy, Jacky and I have noted, the real issue is whether a non-financial industry company can pay its obligations, not what the balance sheet says. A company whose assets at market value are worth less than its long-term debt, but that still has positive cash flow from ongoing operations will be able to stay in business indefinitely, so long as that positive cash flow continues.

If I understand the initial question correctly, it did not refer to banks or financial institutions, but to non-bank/non-financial firms. The only person to answer that question is Timothy Watts. I would like to understand his comment more thoroughly. I look forward to your comments.

John: you have understood the subject correctly. We are discussing about non-bank or non-financial companies. Douglas: I agree with your point of view that there is another situation in accounting terms in market one. but we also should take into consideration Muslim Har Sani Mohamad´s view about risk and higher interests

Negative equity is irrelevant provided the firm/household has the cash flows to pay off the debt as due. Please explain why this view is wrong or correct.

Hello all: I have caught up on this interesting discussion. John--thank you for noting that my comments relate only to non-bank/non-financial firms. Insufficient capital, however defined, has differing consequences for banking institutions. Most public companies do not have banking regulators to worry about. They do have to worry about proper disclosure to investors. This includes disclosures of their financial statements according to generally accepted accounting standards--(for example, U.S. GAAP or IFRS.) Under any reasonable accounting system a company's balance sheet must, well, balance. Therefore, there will always be an accounting for shareholders' equity (or deficit). This accounting, as I noted above, represents the accumulated accounting results of a company since its inception. There is no particular reason that this would be an especially good way to measure a company's value. It may be a good measure, but an investor cannot know that without looking past the company's accounting results. I tried to give a few examples above as to why shareholders' equity can be negative in a perfectly good and stable company. Douglas gave us other examples as to how the market value of assets on a company's balance sheet may not reflect their market value. This can happen with intellectual property as well as with other capital investments. Assets can just as easily be overvalued if the depreciation prescribed according to accounting standards is too small. On the other side of the balance sheet, there are many reasons liabilities may be less worrisome to an investor than an accountant. For example, the accounting treatment of convertible bonds-depending on their features-may require them to be booked as a liability. Bond deals can be very large, and, therefore, a company that issues convertible bonds could find its positive shareholders' equity going negative by virtue of the bond deal alone--depending on what it does with the proceeds. Strong companies may be willing to issue convertible bonds (and endure negative shareholder equity) because they expect to redeem them for cash at maturity or before (based on future performance.) Because the bonds are convertible into capital stock, if these bonds convert into shares of the company, the "debt" suddenly changes to paid-in capital (and a strongly positive shareholders' equity could result.) Though the company now has positive shareholders' equity, one cannot presume that is a good thing, particularly if the conversion of the bonds resulted from a failure to use the proceeds of the bond sale in a way that increased real shareholder value. I hope this additional example helps illustrate why I think investors should be very cautious in equating shareholders' equity (which is an accounting measure) to "shareholder value"--which is not. I think, in the end, increases in shareholder value are what investors expect companies to strive to achieve over time.

John--to directly answer your well-stated question: you are correct that s/h equity has little to no relevance in valuing a company that can pay its obligations when due. Perhaps, in the simplest case, a firm/household's negative equity arose out of the very debt it is now paying off by virtue of a successful investment of its loan proceeds. By using debt rather than sales of equity to finance its successful investment, it has done even better by its shareholders-in a sense. If the firm/household wanted to avoid negative equity at all costs, it would have had to sell capital stock. This approach would have been dilutive to shareholders of the firm prior to the financing.

I guess if the whole balance sheet is not longer reflecting the substantive nature of the company with true and fair view, possibly, business reorganization need to be undertaken to remove negative equity. Nonetheless, the company size can turn smaller. is it good for investor relation? May be not.

With the above, it may happen that companies with negative equity as due to years of accumulated losses but with sustainable positive cash flow from dynamic and strategic business operations as disclosed in the cash flow statements. These kind of companies cannot be treated as similar to companies with negative equity and with negative cash inflows from operation. As the latter has weak earnings quality.

There are two implications for a firm with negative equity. The first is that it is insolvent, thus depending on the laws in the particular country in which it operates, it may be declared bankrupt. The second is the non-availability of attributable reserves, making the firm unable to pay dividends. Thus, if the firm is operating in a country where firms can be declared bankrupt when the value of the assets is less than the value of the promised payments to debt (Stock-based insolvency), as opposed to flow-based insolvency which arises when the operating cash flows are insufficient to cover contractually required payments, then it will normally cease trading. The second point is also important as quoted firms are usually valued on the basis of their ability to pay dividends and if they do not have enough attributable reserves, they may be undervalued.

When I have referred to "shareholder's equity" I have done so in reference to its meaning in accounting only. My first comment noted that this differs from the concept of "surplus" which is, under Delaware law, the availability of funds that may be payable as dividends. Surplus is drawn from a firm's market value not its shareholders' equity. Shareholders' equity is one item on a company's balance sheet. It doesn't measure the firm's market value. That said, it doesn't make analysis of a firm's balance sheet useless. The balance sheet contains immensely useful to investors--but I think investors and litigants cannot rely on one line item in a company's financial statements to either determine its value for investment purposes or to conclusively show a firm is insolvent in a bankruptcy proceeding.

Another aspect to the discussion of the ramifications of negative (book) equity, as the firm would be in financial distress and possibly go bankrupt, is when there have been previous common stock issuances below the stated capital (not always synonymous with par value). That is, depending on (U.S.) state law where the firm is incorporated the share has a specified stated capital amount, e.g. $5 per share. If the firm had originally sold the shares for less than $5 each then the subscribing shareholder has a contingent liabilitty to the corporation to make the firm whole for the difference. For example, if the shareholder purchased the share for $4 they have a $1 contingent liability. When that contingent liability becomes a liability and payment due can be triggered by a bankruptcy and other events. It is possible for the market value of the equity holding of the shareholder to be negative if the market price of the stock is less than the contingent liability of the stock.

As a general rule indefinitely. The question is did the company commit an act of insolvency such as admit it cannot pay a valid due liability. If it does it can be liquidated even if it is technically solvent. I say generally because in some cases action can be taken against a technically insolvent company as in the case of insurance companies

Raymond, you made an important point. This is the reason that companies that go public arbitrarily set the face value of their common stock to a trivial value of $0.01 or $0.02 or some such silly amount.

Raymond-what are the differences that you have seen between "stated value" and "par value"? I recognize the potential of liability from watered stock, as a general matter. In practice, however, Premal's point is apt. To be fully paid and non-assessable when sold, only par (or stated) value must be paid. There are potential other problems (e.g. tax) for selling shares below fair market value--however those are not questions of corporate law. Many U.S. states allow for no par value shares. I am interested to hear your experiences with "stated value" that might differ.

At what point will negative earnings morph into negative equity...any modeling done on that? The EV [enterprise value = D + E] can remain non negative even with negative equity, which will keep the company 'alive' ... so theoretically the answer would be 'indefinite'...

Retained Earnings from the Income Statement are carried over to the Balance Sheet and added to Accumulated Retained Earnings under Shareholders' Equity. If retained earnings in any one year are negative, assuming that no other changes have occurred to Shareholders Equity, the balance under Shareholders' Equity is reduced by that amount. Thus, if a firm continues to have negative retained earnings, it will continue to chip away at the Shareholders' Equity until that becomes zero or negative.

During the dot com bubble many firms began with small Shareholders Equity amounts and had 2-3 years of negative retained earnings -- thus, it wasn't unusual to find many firms with negative equity.

Timothy- I do not have any collected empirical evidence of firms , by state and time period, selling their stock for a price below the stated capital amount per share . My point was that this does happen. Typically, but not always, par value equals the stated capital amount. Further, this is another aspect to the discussion of negative (book) equity and how from an individual stockholder's view they may have a negative market equity value.

I have an other questions regarding the discussion: do you know other countries where a negative (book) equity is permitted?

Pankaj - I know other equation for enterprise value: EV = market value+debt-cash. See also http://www.investopedia.com/terms/e/enterprisevalue.asp. The equation could be changed if you see other relevant parameters.

In Romania, some companies have negative book equity for many years.

As far as I know In Slovakia companies with negative book equity after 60 days should be filed for bankruptcy

GAAP book value of equity is Acc. retained earnings-Treasury stocks+Comprehensive income+Deferred Compensation+Equity Adjustment+Subscribed Share Capital+Foreign Currency Translation Adjustment+Minimum Pension Liability+

Accumulated Currency Gains/Losses+Distributions In Excess of Earnings.Thus, there are as many reasons for a negative GAAP book value!!!

In the case of AKS, sustained historical losses (it decreases Acc. Retained earnings) and increase in treasury stocks contributed to that negative value. Does it matter? not really. In fact, I am more concerned about AKS producing $0.05 EBITDA on a $1 revenue. Those $0.05 have to pay for $0.02 in interest exp....and you don't have much equity creation here. ;-)

In Italy, in theory it can survive for some months but then the shareholders should decide for the winding-up or to make new conferment. In practice, unless some creditors ask to the courthouse to declare its bankruptcy, the company can survive for an indefinite time (but then the shareholders and the directors can have some troubles...)

Oh yes

My answer is not a response to specialists but rather a very general response (it may help non specialists) :

If Negative equity is not a problem of itself for company survival, we may noticed that negative equity is the result of past losses that will translate (especially if there is many consecutive annual losses) in negative cash-flows and difficulties to pay its suppliers and refinance itself.

Hence, we can distinguish two cases :

- First the company as a "company surplus", as defined by Timothy Watts : that means that for this (listed) company, the shareholders are still willing to refund the company despite its past losses. In this case the company can survive as long as the shareholders keep this opinion.

- Second case : the company has no surplus (or is not listed and has no known shareholders). In this case, the company will probably encounter difficulties to refinanced itself and to pay what it owes. The company can not borrow to the bank anymore, hence it will probably die (suffocated by lack of available cash).

That is a good distinction. A company in the second case (where it doesn't have "surplus" or has negative surplus) is in a very precarious legal position. Drawing on my example from Delaware law, not only cannot such a company legally pay dividends, it said to be (under Delaware law) in the "zone of insolvency." Being in or near the zone of insolvency is legally important because officers and directors fiduciary duties begin to shift from the corporation's stockholders to its creditors. Delaware law assumes that the shareholders-at some point-hold worthless shares. As such, directors and officers have a duty to protect creditors (such as bondholders) that may be the only investors that continue to have any substantial valuable interest in the company.) Director liability here can become a serious concern because the questions of legal duties and loyalty become complex.

Companies such as these are rarely (with very notable exceptions) listed on a major U.S. exchange (or any major global exchange). Such companies, if they were public, would have typically been delisted at some point during their decline (where they first failed to meet market cap, per share value (e.g. $1), or other listing requirements.) Where a U.S. company is insolvent and is unable to reorganize its debt by negotiation, the most likely appropriate (and legally wise action) would be it to seek relief afforded it under the U.S. Bankruptcy Code.

There is a special business model corrsponding to the second case of Frédéric Perdreau's classification - a pyramid scheme.

Various forms of pyramid schemes are illegal in many countries including Albania, Australia, Austria, Brazil, Canada, China, Colombia, Denmark, the Dominican Republic, Estonia, France, Germany, Hong Kong, Hungary, Iceland, Iran, Italy, Japan, Malaysia, Mexico, Nepal, the Netherlands, New Zealand, Norway, the Philippines, Poland, Portugal, Romania, Russian Federation, South Africa, Spain, Sri Lanka, Sweden, Switzerland, Taiwan, Thailand, Turkey, Ukraine, the United Kingdom, and the United States.

We can find some stock-listed companies with negative equity. I happen to have been serving on a non-profit organization with negative equity as a treasurer, so I know that it would not be the balance sheet but a failure to make required payments that triggers serious situation.

Yes, if the present cash flows are sufficient to pull on, the future turn - around in equity values can come . If there is hope for future turn- around also, it should be ultimately financed by some body or other!

Sorry , I meant if there is no hope for future turn- around in equity values !