Dictionary

Meaning of Negative Equity

As an entrepreneur, you must strive to keep your company in the black. Only if you can make a profit is it possible to operate permanently in the market. Writing in the black means that you are not creating negative equity in your company . But what exactly does negative equity mean, what can you do if it is there and how can you offset negative equity?

What does negative equity mean?

In order to explain exactly what negative equity is, the term equity should first be defined. The equity results from the amount that is still left after deducting all debts from the so-called active assets. Simply put, equity is the balance of assets and liabilities . Accordingly, negative equity arises when your company has too much debt , in short, is over-indebted.

What resources make up your equity?

Equity usually consists of two different funds.

  • financial resources that you as an entrepreneur provide yourself
  • Profits left in the company for self-financing

The equity, which represents a part of the total capital of your company, belongs to all owners. To the entrepreneur it represents a kind of liability of the company and how the equity is to be shown is regulated in § 272 HGB . And precisely as a counterpart to equity, a company also has outside capital . This is also counted towards the total capital of your company. If the assets in your company are now lower than the debt capital , then your company is over-indebted.

Every company has total assets and a so-called capital contribution. Over time, the company creates additional assets. But if you, as an entrepreneur, accept outside capital that exceeds the value of the company’s total assets, then your company has negative equity. This corresponds to an under-balance sheet and states that a corporate liability is greater than the available capital.

Where do you need to list negative equity on the balance sheet?

Equity, including negative equity , is always listed in the balance sheet under liabilities . You should note that in the case of a corporation, it includes the defined balance sheet items, as described in Section 266 (3a) of the German Commercial Code (HGB ). Assets, as liabilities , always represent the source of funds and with existing capital, in the case of assets , the use of funds is always shown. The following subdivision applies to you.

assets liabilities
Current assets Bank and cash balances
Capital assets Capital assets
Active accruals and deferrals requirements
Other assets
Tangible assets
Real estate assets

Calculate equity

Usually the two sides of assets and liabilities are always balanced when you look at your balance sheet. However, it may well be that the liabilities side predominates . This means that there is over-indebtedness. In this case, the value of your company’s equity falls below zero and this means that it is considered negative equity . Let’s take the following example.

Calculation example

Active assets 100,000 euros
– debt capital on the liabilities side 250,000 euros
= negative equity of 150,000 euros

Specifically, this means that you have a debt of 150,000 euros with your company.

Difference in equity depending on the legal form

If you run a sole proprietorship , you can use your equity in a variety of ways . You can lower or raise it by any amount. This is not so easy with corporations and is regulated by law and by the articles of association. From this you can see which parts of the capital may not be changed. In the balance sheet, equity comprises the following balance sheet items.

  • Subscribed capital
  • Retained earnings
  • Capital reserve
  • Annual surplus and annual deficit
  • Carry forward profit or loss

Tip!

You can determine whether you made a profit or a loss in the profit and loss account . You can easily create this using our free income statement template .

Even in a partnership , equity is regulated by the articles of association, articles of association and law. All shareholders determine in advance which shares cannot be changed. For this reason, two accounts are made available to each partner. On the one hand, the fixed capital account 1 and, on the other hand, the changeable capital account 2. Furthermore, depending on the legal form, there are differences as to where the negative equity must be in the balance sheet .

legal form description
one-man business For sole proprietorships , the capital account is always displayed as a sub-balance account on the assets side. The positive capital account can be found on the liabilities side.
Corporation Here the sub-balance sheet is indicated by the asset item “Deficit not covered by equity. This corresponds to the requirement according to § 268 III HGB .
Partnership In the case of partnerships , the sub-balance is the sum that results from the negative capital accounts. This also makes the capital accounts of all shareholders negative.

The importance of negative equity to your business

If you have negative equity in your company , this is generally not a good sign . The occurrence of negative equity is very common, especially during economic recessions . If your company is over-indebted, you will not be able to work profitably. In most cases it is a sale or even bankruptcythe consequence. So if you have negative equity in your company, you must immediately check whether bankruptcy should be filed. This is the only way to initiate countermeasures in good time. In the case of negative equity, layoffs of employees are often unavoidable. On the other hand, operations are difficult to maintain even without employees.

What measures can you take if you have negative equity?

Equity always represents the share of owners in the company’s assets . With this equity, your company is liable to the creditors . If you now have a shortfall or negative equity, it is no longer possible to service the debts with this financed asset. Taking out a loan is very difficult or almost impossible in such a situation. For you, however, negative equity does not necessarily mean that bankruptcy can occur. There are a few options available to you to offset negative equity.

Check all assets

First of all, you should examine all of your company’s assets . Just looking at the accounts does not always provide sufficient information about how the assets are really doing. When checking, however, you must ensure that all debts that are not reported are also taken into account . In many cases, older companies in particular have hidden reserves with which to offset negative equity.

Shareholders grant grants

In the case of negative equity, it is also worth considering a subsidy from the shareholders . In this case, the shareholders pay in enough to compensate for the negative equity and the insolvency law must be invalidated. If you have enough personal wealth , this can be a fairly easy step. If a partner does not participate in a grant, this can also be negative for him. Subsidies from the other shareholders also change the shares in the company and also the rights of participation.

In a nutshell: Frequently asked questions about “negative equity”

What does negative capital account mean?

The negative capital account is shown on the assets side of the balance sheet . A negative capital account usually arises from changes in sole proprietorships and partnerships combined. If withdrawals and losses of liabilities are higher than the available assets, the negative capital account results.

Can the balance be negative?

If the debts of a company are higher than the company’s assets , the result is a negative balance sheet total . However, negative balance sheets can be offset by profits from previous years.

What is a deficit not covered by equity?

The moment the losses on the liabilities side exceed the assets , a deficit arises . Put simply, the debt is higher than the wealth. In accounting, this difference is posted as a deficit that is not covered by equity.

Conclusion

If the debt capital on the liabilities side is higher than the assets , negative equity is created . The position of negative equity in the balance sheet depends on the legal form to which the company belongs. Negative equity can be very dangerous for a company if it fails to offset it through other means. Very often the result is bankruptcy or the sale of the company. Therefore, counter this early enough and always keep an overview of your finances.

Negative Equity