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4 Reasons for Negative Equity

4 Reasons for Negative Equity

Did you know that there are both positive and Negative Equity? Equity, also known as shares and stocks, is something every trader is familiar with.

But what is negative equity? Let us take a look.

Before we answer this question, it is important to know the basics. Equity in the stock market, or shareholder’s equity, refers to the monetary value of a company after deducting its liabilities from its total assets. Shareholder’s equity is the total worth of the company and determines the company’s ability to pay back the traders who have bought securities in the company.

Negative equity occurs when the company’s liabilities are greater than its total assets. It means that even if all of the company’s assets were to be liquidated, it still might not be enough to pay back the traders.

Negative equity due to Decline in the Value of Intangible Assets.

Copyrights, trademarks, patents, or any other intellectual property are said to be intangible assets. One of the most prominent reasons for a company’s negative equity is the decline in value of these intangible assets due to them becoming obsolete either due to them being outdated, or being entirely refuted by another intellectual property.

Negative equity due to Accumulated Losses.

When a company faces loss over subsequent quarters, it is called accumulated loss. Accumulated loss can be mitigated by the profit generated by the company in those quarters, as well as its pre-existing assets, therefore it is not inherently a bad thing. But when the accumulated loss is greater than what can be safely covered by the company’s assets, then the company is said to have negative equity.

Negative equity due to Borrowed Money.

Taking out a loan or borrowing money from someone and not being able to pay back the full amount in time is a common enough story nowadays. It is also true in the case of companies as well. When a company as an entity takes out a loan from a bank or borrows money from any other source, but is then unable to return the money due to lack of profits or any other unexpected financial problems, then the company is said to have negative equity.

It is to be noted that companies being unable to return their borrowed assets could be a sign of fraud in the stock market as well.

Negative equity due to Large Dividend Payment.

A dividend is the interest on an investor’s bought security which a company pays when traders sell the securities back to the company itself. An increase in liabilities occurs when these dividends are greater than the company’s assets. Thus, it is important for any publicly listed corporation on the Indian Stock Market to keep their dividends balanced with their projected profits.

How does negative equity affect investors?

In the simplest of terms, it will result in traders losing money on their trades. They may end up not receiving any dividends should the company liquidate the entirety of its assets as well. Negative equity can also affect traders engaged in short-term trades, such as intraday trading and swing trading as well.

Therefore, it is advised that investors should thoroughly examine a company’s balance sheets over several quarters before trading in their securities to prevent loss on their trades.

However, negative equity does not always mean that a company has liabilities due to unsound business decisions. Sometimes, a company may borrow funds or use the majority of their assets in order to improve their existing infrastructure, which would lead to profits in the future. This is usually in the case of start-ups.

We hope that through this article our readers will understand the importance of thorough research before trading. If you wish to learn more about the Indian stock market, and the various terms used in this article in greater detail, you will find the related articles on the Stockmasters blog.

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