0

I'm reading this text about elementary concepts in finance. It keeps repeating an example where a company reinvests part of its profits (earnings), and claims that this increases the book value of equity.

However, wouldn't reinvesting increase the value of the company's assets instead and reduce the book value of equity? I mean, if you re-invest part of earnings in e.g. inventory, you would increase the value of assets, not equity, correct?

Technically, isn't the book value of equity just the difference between assets and liabilities? So if you add to assets, you are taking away from equity, not adding to it, right?

2

The book value is Total Assets minus Total Liabilities and so if you increase the Total Assets without changing the Total Liabilities the difference gets bigger and thus higher.

Consider if a company had total assets of $4 and total liabilities of $3 so the book value is $1. Now, if the company adds $2 to the assets, then the difference would be 4+2-3=6-3=3 and last time I checked 3 is greater than 1.


On definitions, here are a couple of links to clarify that side of things.

From Investopedia:

Equity = Assets - Liabilities

From Ready Ratios:

Shareholders Equity = Total Assets – Total Liabilities

OR

Shareholders Equity = Share Capital + Retained Earnings – Treasury Shares


Depending on what the reinvestment bought, there could be several possible outcomes. If the company bought assets that appreciated in value then that would increase the equity. If the company used that money to increase sales by expanding the marketing department then the future calculations could be a bit trickier and depend on what assumptions one wants to make really.

If you need an example of the latter, imagine playing a game where I get to make up the rules and change them at will. Do you think you'd win at some point? It would depend on how I want the game to go and thus isn't something that you could definitively say one way or the other.

  • 1
    Thanks, that clarifies it a bit. However, Earnings is part of shareholder's equity. So if you reinvest part of earnings, aren't you subtracting from equity? – charger001 Jun 22 '16 at 20:50

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.