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Shareholders Equity: Retained Earnings and Contributed Business Capital

Last time we went through the financial definition of debt, now here we will go through the financial definition of owner's equity (or shareholder's equity) and consequently the definitions of retained earnings as well as contributed business capital.

While you may understand very much, having too much debt is definitely no fun and is even dangerous for any corporation. Debts or liabilities are financial claims that are effective by laws for most countries. These laws do give creditors, who are people lending out their money, necessary legal rights to make lenders bankrupt or push for selling assets of lenders if they fail to pay back their debts before deadline. So having too much debt can often adversely affect a company's valuation and its share price if it is already publicly listed. Management team of every listed company should therefore well-control its debt within an acceptable level in order to maintain investor confidence and protect its stock price performance.

What is Owner's Equity (or Shareholder's Equity)?

In fact, creditors do have many legal protections and legal rights over their corresponding owners. According to laws, creditors must be paid for complete financial payment even their related owners do not receive anything. For this reason, it is likely that a debt (or liability) can consume all financial resources of a company. Furthermore, owner's equity, by definition, is a financial claim that business owners shall make in regards to overall assets they already have. This is also the remaining assets or residual interest of a business after deducting their entity liabilities. Below is a basic accounting equation of owner's equity:

Owner's Equity = Assets - Liabilities.

For a particular business corporation, owner's equity can also be referred as shareholders equity. Therefore, above accounting equation relating to liabilities and assets can thus become:

Liabilities = Assets - Shareholder's Equity.

What are Retained Earnings and Contributed Business Capital?

Consequently, shareholders equity (or stockholders equity) actually has two separate financial portions, which are the retained earnings and contributed business capital. As a result, accounting equation for retained earnings and contributed business capital is:

Shareholder's Equity = Retained Earnings + Contributed Business Capital.

By definition, the amount of money that an individual shareholder contributes to a business is called the contributed business capital. Also, contributed capital can be divided financially into two distinct portions, by definition, which are 'par value' as well as 'extra paid in capital'.

Another financial term you should know here is retained earnings. Retained earnings, by definition, are the amount of reserved equity or reserved profits by a business. Retained earnings of a business are actually earned by shareholders due to profit-generating activities but are reserved for future uses of its business operation.

3 Kinds of Financial Transactions For Retained Earnings

Normally, retained earnings are subject to three kinds of financial transactions. These retained earnings are namely: dividends, expenses and revenues. Below are the basic definitions for these retained earnings:

By definition, a decrease (or increase) in stock can become expenses (or revenues) respectively. This is applicable to any business operation, no matter offline or online. For example, if your business is online and you do have your own operating website, then your operating expenses are mainly your hosting service fee as well as domain name registration fee. Another example is that if a consumer promises to pay you in advance for a service your company will provide in near future, then the money should be recorded as accounts receivable (for financial asset account). Accounts receivable can increase the total asset value that your company owns but also decrease the shareholder's equity amount that is known as an example of so-called revenue.

That is all for this accounting-related blog post about shareholder's equity as well as its relation between assets and liabilities. In our next accounting-related blog post, we will continue to write about exact business relationship between three kinds of financial transactions for retained earnings (i.e.: dividends, expenses and revenues). So please keep watching and enjoy!

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