Introduction
Book value is a financial ratio to identify the fundamentals of the company. Although there are several criteria that investors can use to determine the worth of a company’s shares, one of the most prominent way is book value.
The book value of a company can be used to determine whether a stock is reasonably valued, overvalued, or undervalued.
What is book value of a company
Book value is defined as the net value of a company’s assets, as shown on its balance sheet. It is roughly equivalent to the total amount all shareholders would get if the company were liquidated.
Book value is the value of a company based on its books of accounts, as indicated on its financial statements. It is, in theory, what investors would receive if they sold all of the company’s assets and paid off all of its debts and liabilities.
A negative book value indicates that the stakeholders will have to further pump in extra cash in the the case of company closure to pay the outstanding debts.
Mathematically, book value can be defined as,
Book value = Total Assets – Total liabilities
Diving this number by the total number shares of the company, we can book value per share.
Also Read: How To Value Stocks Using Sum Of The Parts (SOTP) Valuation Model
Here are the reasons why a book value of a company can be negative
When the liabilities of the company are more than the assets
The situation where the liabilities of the company are more than its assets is the prime reason for the book value of the company to be negative. Liabilities can be in the form of company long term debts, high interest payment or pledged promoter shares.
When the liabilities are higher, the company practically does not own any of the assets of the company. These assets are freezed and are booked in the banks from which they have lent the money. Thus, creating a negative book value.
When the company has negligible assets
When a company has negligible assets, it tends to have a negative book value when the company incurs a loss in a particular financial year. This states that the losses bared by the company are more than the equity and reserves it holds.
This can be a challenging situation for the company as the company will have to either reduce their expenses or sell their stake in order to over come such losses.
When the company has negative cash flow
A negative cash flow indicates that the company has more expenses then the income it makes.
In the case of a growth stock, when the company concentrates on business expansion or client acquisition, profits are re-invested in the business and more money is borrowed from banks to cover losses.
A negative cash flow for the business results in may financial crunch for the company.
When the company incurs losses
When the company incurs losses in the business, it tends to take loans in order to recover from the losses. This in turn increases in the liabilities of the company, making the book value to be negative.
What does a negative book value indicate
A negative book value not only indicates the financial instability of the company, but also the magnitude of financial instability.
A declining book value tells us that the company is having huge outstanding liabilities and high interest loan payments. Having these outstanding liabilities can also indicate that the company also go under closure if not tackled appropriately.
Conclusion
A negative book value does not particularly indicate that the company is in a bad financial shape. There are a bunch of other factors that one needs to consider to make desired conclusions. Having a debt on the company can mean that the company is in the process of expansion for future growth, which is a positive aspect.
Also Read: What Is The Difference Between Intrinsic Value And Market Value
