When a company's depreciation is larger than its gross investment, net investment becomes negative and the firm's capital stock decreases?

krishna-agrawala | Student

It appears that the question has mixed up lot of terms. But it looks like the core of the question is the impact of Net losses on the net worth of the company.

Before I discuss this question, let me try to clear some of the confusion apparent in the question. First we will take up the issue of investment, capital and stock. Investment generally refer to the total sum of money employed in the business. This investment may be used for creating fixed assets or for working capital. The word capital is another name employed for the money invested in a business. This capital may be provided to the business by the owners of the business or may be in the form of loans. In general, for joint stock companies, the owners capital called the net worth. This new worth is equal to the amount collected from the shareholders for the shares issued, called stocks issued and paid up, plus cumulative retained profits. In case the company has cumulative losses rather than profits than these losses will need to be subtracted from the stocks paid up to get the amount of net worth.

Depreciation is charged on the fixed assets and represents the reduction in worth of the fixed assets with time and use. Please not that the effect of depreciation on the business profits or investment is same as any other expenses. There is no additional link between depreciation and investment. Further, depreciation causes the net value of the fixed assets to decrease by the amount of depreciation. Thus we talk of gross value and net value of fixed assets. The term gross and net are generally not applied to investment. Also in some cases the fixed assets are also called capital assets, but thee is nothing like 'capital stock'.

I hope I have cleared most of the confusion and we can get down to discussing the impact of losses on net worth of the company. When a company makes losses, that is when its expenses in various forms including depreciation exceeds its revenues the net worth of the company gets reduced by the loss amount. Please note that though the net value of fixed assets gets reduced by an amount exactly equal to the depreciation, there is no direct relationship between changes in net worth and depreciation. Also note that profit or loss do not have any impact on the amount of paid up stocks. What changes is the retained profits. When retained profits are positive, the net worth is more than stocks paid up. When the accumulated profits are negative, which means the company has accumulated loses rather than profits, the net worth is less than the paid up stock by amount of losses. The net worth becomes negative when the accumulated losses exceed the paid up stocks amount..