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Equity capital and companies’ strength

Friday 25 November 2011, by Romain Sautard

In this period of doubts and uncertainty in the global economy we are facing these latter weeks, and that had reached its peak last week with the announce of the Greek referendum (aborted) and the resignation from Papandréou in Greece and Berlusconi in Italy, it is important to have indicators allowing to know if European economies are strong enough to face an important crisis.

One of these indicators could be the amount of equity capital of the companies of a country. Indeed, equity capital, equivalent to the net assets of the companies, is very important for a company as it acts as a shock bumper in case of financial difficulties. An analysis of equity capital of the companies of a country will give an idea of the global strength of an economy.

Such an analysis performed on France highlighted that French companies are undercapitalized compared to British companies, limiting their growth potential and their survival chances in case of financial crisis.

Defining equity capital

Equity capital, or capital stock, is capital raised at the company creation to which are added the accounting profits of the tax year, retained earnings (for companies with stockholders) and capital raised.

From an accounting point of view, equity capital is the sum of the assets of a company (buildings, lands, intangible assets, etc.) less total debts. Equity capital is also called net assets.

Role of equity capital

The main advantage of equity capital of a company is to act as a security blanket for company creditors. This is because, during the life cycle of the company, profits are added to equity capital and losses are subtracted. Thus, in case of substantial losses, the more important equity capital, the more a company will be able to bear these losses. In the opposite case, equity capital could become negative; creditors are then not sure to be reimbursed in case of default as the debt is larger than the total assets of the company (buildings, materials, etc.) pledged to creditors. The resale of assets will not be sufficient to cover the debts.

The probability of survival will then be more correlated to the amount of a company equity capital than to its size. A large company with too small an equity capital could quickly disappear.

When equity capital is underfunded (undercapitalized), that could lead to a solvency crisis. Moreover, undercapitalization is generally linked to a higher debt cost, creditors asking a higher interest rate due to a higher risk.

Equity capital is used by financial analysts to derive a reevaluated net asset that they then compare to the market capitalization of a company. If this latter is lower than the reevaluated net asset, the company is underevaluated.

Comparison of the companies’ equity capital in France and in United Kingdom

Analyzing the amount of equity capital in a country, without international comparison, is lacks credibility. This is why IRDEME has compared the amount of equity capital owned by French and British companies.

The first study consisted in measuring the total amount of equity capital of all companies in both countries:

The gap between the two countries is important when considering the total of equity capital. This gap is even more important when looking at large companies.

This difference in equity capital comes from the fact that British companies are more capitalized at their creation but also due to the fact that capital contribution during the life cycle of a company is more important in United Kingdom. Tables above highlight this opposite dynamism:

Table 1. Evolution of the number of companies born in 2002 by size of equity capital in United Kingdom (in Euros)

Equity capital
2003
2004
2005
Evolution 03-05
<500k
156 299
149 682
125 26
- 19,9%
(89.4%)
(85.6%)
(71.6%)
0,5-1M
526
966
1 471
+ 179,7%
(0.3%)
(0.6%)
(0.8%)
1-2M
338
521
742
+ 119,5%
(0.2%)
(0.3%)
(0.4%)
2-5M
270
350
517
+ 91,5%
(0.2%)
(0.2%)
(0.3%)
5+M
348
455
533
+ 53,2%
(0.2%)
(0.3%)
(0.3%)
Dead/No balance sheet
17 043
22 850
46 300
(9.7%)
(13.1%)
(26.5%)
Sample size
174 824
174 824
174 824
Source : pH Group

Table 2. Evolution of the number of companies born in 2002 by size of equity capital in France (in Euros)

Equity capital
2003
2004
2005
Evolution 03-05
<500k
58 882
54 034
38 836
- 34,0%
(86.3%)
(79.2%)
(56.9%)
0,5-1M
728
879
876
+ 20,3%
(1.1%)
(1.3%)
(1.3%)
1-2M
434
538
535
+ 23,3%
(0.8%)
(0.8%)
(0.8%)
2-5M
290
339
331
+ 14,1%
(0.4%)
(0.5%)
(0.5%)
5+M
296
360
313
+ 5,7%
(0.4%)
(0.5%)
(0.5%)
Dead/No balance sheet
7 623
12 103
27 362
(11.2%)
(17.7%)
(40.1%)
Sample size
68 253
68 253
68 253
Source : pH Group

These tables highlight that, for companies born in 2002, the equity capital growth rate of French companies was significantly lower than equity capital growth rate of British companies. Indeed, whereas the number of companies with equity capital over 5 million Euros increased by 5,7% in France over the 2003-2005 period, it increased by 53,2% in United Kingdom. This difference is almost the same for all equity capital size.

These results are in line with a previous study on companies having more than doubled their equity capital in France and United Kingdom.

Conclusion

This difference in equity capital growth flows from several reasons. The main one is that equity capital growth during the life cycle of a company comes essentially from accumulated earnings. British companies’ profits are higher than those of French companies, so earnings accumulation is lower in France.

Another reason could be the level of merger and acquisition in an economy. Indeed, two merging companies bring each equity capital to a new structure that, by definition, will have higher equity capital. However, an analysis of the merger rate in both countries on a small sample has not found significant differences between the two countries.

Whatever the reason of the gap observed between the two countries is, French companies are undercapitalized in comparison to British companies. In dynamic growth period and prosperity, undercapitalization is not a risk, even if it constrains the mid-term and long-term growth of companies. However, in a unfriendly environment, it is not sure that French companies can face a crisis in the same way than British companies do.

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