Can't balance a balance
What does negative equity mean?
Negative equity: definition
Before we turn to negative equity, let's first define equity in general. The term equity means the amount that results after deducting all debts from the assets. The amount is therefore the balance of assets and debts (“residual value”). With the equity, both sides of the balance sheet are balanced.
The equity consists of these funds:
- Financial resources provided by the entrepreneur
- Profits that are left in the company to self-finance the company
The shareholders' equity, part of the company's total capital, belongs to the owners. It represents a certain liability of the company towards the entrepreneur. How the equity is shown is regulated in § 272 HGB. In the same way as equity, there is borrowed capital, which is also counted as total capital. A company whose assets are lower than its debt capital is over-indebted.
Every company has total assets and a capital contribution. Over time, an asset pool is also built up. If a company accepts outside capital that is worth more than its total assets, it has negative equity, which corresponds to an under-balance sheet. This means that the liabilities are higher than the available capital.
Negative equity on the balance sheet
In the balance sheet, equity is listed under liabilities. In the case of corporations, it includes the balance sheet items defined in Section 266 (3a) of the German Commercial Code. It stands next to borrowed capital and deferred income. While the source of funds is shown for the liabilities (assets), the use of funds is shown for the assets (available capital).
The assets are divided into three parts:
- Current assets
- Capital assets
- Active accruals and deferrals
The assets are as follows:
- Cash and bank balances
- Capital assets
- Real estate assets
- Tangible assets
- Other assets
Calculation of equity
Usually the asset side and the liability side are balanced on the balance sheet. However, if the liabilities side predominates, over-indebtedness occurs. Then the value of the equity falls below zero and is therefore considered negative equity.
200,000 euros (assets) - 350,000 euros (debt capital on the liabilities side) = - 150,000 euros (negative equity)
The company now has debts of 150,000 euros.
Equity according to legal form
Equity is variable for sole proprietorships. It can be increased or decreased at will.
In corporations, the law and the articles of association determine which portions of the capital are unchangeable. Equity comprises these balance sheet items (see Section 266 (3a) of the German Commercial Code):
- Subscribed capital
- Capital reserve
- Retained earnings
- Profit carryforward / loss carryforward
- Annual surplus / annual shortfall
In addition, there are shares of other shareholders (minority shares) within equity in the consolidated balance sheet (see Section 307 (1) HGB). A separate item, a “shortfall not covered by equity capital”, must also be shown on the assets side (cf. Section 268 (3) HGB). For all business people, the equity is shown separately and broken down in the balance sheet. There are no special requirements for the shape. The capital account is used to post private deposits and withdrawals outside of the balance sheet and profit and loss account.
In the case of partnerships, equity is determined by law, in the articles of association and in the partnership agreement. The shareholders determine in advance which shares are unchangeable. Each partner receives two capital accounts: a fixed (capital account I) and a variable (capital account II). In a limited liability partnership for which no natural person is fully liable (e.g. GmbH & Co. KG, UG & Co. KG), the provisions of Section 264c (2) of the German Commercial Code (HGB) apply. The capital shares of the shareholders are shown under the balance sheet item.
The location of the negative equity in the balance sheet differs depending on the legal form:
- One-man business: The capital account is shown as a sub-balance account on the assets side, while the positive capital account is shown on the liabilities side.
- Corporation (e.g. GmbH, UG, AG): The sub-balance sheet is indicated by the asset item “Deficit not covered by equity capital” (Section 268 III HGB).
- Partnership (e.g. GbR, KG): The sub-balance results from the sum of the negative capital accounts. The shareholders' capital accounts become negative.
Significance for companies
Typically, negative equity, which often occurs during economic recessions, is a bad sign for a company. With high levels of debt, it cannot be economically viable and must therefore be sold or reported as bankrupt. In the event of bankruptcy, a special liquidator determines the bankruptcy estate. Then the creditors can make their demands. If your company has negative equity, you have to check whether there is an insolvency law fact in order to be able to initiate countermeasures in good time.
If a company's equity is negative, it becomes uneconomical to make new investments. Paying the employees is also made more difficult, so that there have to be layoffs. If the employees cannot be financed, it becomes increasingly difficult to guarantee operations, so that in the worst case scenario it has to be abandoned.
Measures against negative equity
The equity represents the share of the owners in the company's assets. That means: With the equity, the entrepreneur or the company is liable to the creditors. If the equity is missing, i.e. negative, the assets on the balance sheet are not sufficient to cover the debts. This is problematic, among other things, when borrowing from banks. Loan applications from indebted companies are usually rejected.
Finding negative equity does not mean that the company must file for bankruptcy immediately. There are various ways to offset negative equity.
One possibility is the shareholder allowance. One or more shareholders pay enough money into the company to compensate for the negative value of the equity. This invalidates the facts of the insolvency law. This solution is easy to implement with sufficient private assets, but it is a disadvantage for the shareholders who do not participate in the compensation. Because this will reduce their company shares and co-determination rights as a percentage.
Examination of assets
In some cases, an examination of the assets can reveal whether a valuation of liquidation values leads to a different conclusion than looking at the accounts. Such an assessment can remove the insolvency law overindebtedness. When calculating with liquidation values, however, undisclosed debts should be taken into account. This strategy can be particularly useful for long-established companies with many hidden reserves.
A going concern forecast should be made for start-ups with negative equity. A cash flow forecast is carried out to assess whether the company can settle its debts in the future. The managing director uses the existing business plan as a reference. When doing this, make sure that your plan values are as realistic as possible. The aim is to objectively assess the possibility of debt settlement.
The information published on our site is all written and checked by experts with the greatest care. However, we cannot guarantee the correctness, as laws and regulations are subject to constant change. Therefore, always consult a technical expert in a specific case - we will be happy to put you in touch.
firma.de assumes no liability for damage caused by errors in the texts.
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