Capital stock serves as a foundational element in a company’s financial structure, representing the authorised shares available for issuance. This facilitates the raising of capital, enabling business development and growth. Understanding capital stock is essential for finance professionals and investors. In the following article, we will explore its various facets, merits, and limitations.
What is capital stock?
Companies seek various ways to raise capital to fuel growth, pay off debts, and invest in new projects. One of the most common methods is through the issuance of shares. In this practice, the company offers portions of its ownership, known as capital stock, to investors.
Capital stock is essentially the total number of shares that a company is authorised to issue, as per its articles of association. These shares are accounted for under “Owner’s Equity” on the company’s balance sheet.
For example, consider HDFC’s balance sheet for FY23. The authorised capital stands at 6,50,00,00,000 equity shares, each with a par value of Rs. 1. This figure remained consistent with the previous year, as of 31 March 2022. In monetary terms, this translates to Rs. 6,500,000.
By acquiring capital stock, investors essentially purchase ownership stakes in the company. This entitles them to a proportionate claim on the company’s assets and earnings, often in the form of dividends.
In addition to financial gains, stock ownership can also carry voting rights, giving shareholders influence over company decisions. Thus, capital stock serves dual roles: it allows companies to raise funds for various activities while providing investors with the opportunity to become partial owners of the business.
Types of capital stock
First, the Board of Directors sets the maximum number of shares a company can issue, known as authorised shares. These can be divided into two main categories: common stock and preferred stock.
- Common Stock: It is usually what people refer to when discussing stocks. These shares come with voting rights, enabling holders to influence company decisions. However, dividends aren’t guaranteed, and they are last in line during liquidation.
- Preferred Stock: Holders of preferred equity shares don’t usually have voting rights, but they do get priority in dividend payments and during liquidation. These shares offer a more stable but limited growth opportunity.
You may like: Unlocking the power of preference shares
Beyond these main types, we have:
- Issued Shares: These are authorised shares that investors have bought.
- Unissued Shares: The company holds these shares as authorised but unsold stock.
- Treasury Shares: These are shares that the company has repurchased and currently owns.
- Outstanding Shares: These are issued shares currently held by external investors.
Determining the value of capital stock
Calculating the common stock balance involves multiple approaches. The most basic method considers the par value. Par value is an arbitrary figure set at the time of share issuance for financial reporting.
To know more: What is face value?
Steps for calculation
- Identify the number of shares issued: Check the balance sheet for the number of both common and preferred shares issued.
- Note the par value: Available on the stock certificate or balance sheet, this is the arbitrary per-share value set by the company.
- Calculate using formula:
Value of Capital Stock = Number of shares issued * Par value per share
= (Number of Common Shares Issued × Par Value of Common Shares) + (Number of Preferred Shares Issued × Par Value of Preferred Shares)
Example
Let’s consider an example to understand capital stock economics using a fictional company named “GreenTech.” The company has issued 3,000 common shares at a par value of ₹100 and 2,000 preferred shares at a par value of ₹120.
Using the formula:
Value of Capital Stock=(3,000×₹100)+(2,000×₹120)=₹3,00,000+₹2,40,000=₹5,40,000
So, in this example, the value of GreenTech’s capital stock, as calculated using the par values, would be ₹5,40,000.
Benefits of capital stock
Financial flexibility: Capital stock enables companies to raise funds without accumulating debt. This is a boon for companies as it doesn’t add to their fixed costs, keeping the balance sheet healthier.
Business expansion: The capital raised is often used to facilitate growth activities like acquisitions or purchasing new assets such as machinery or property. This enables companies to expand without leveraging too much debt.
Dividend payouts: For investors, capital stock isn’t just about potential capital appreciation. Many are also attracted by the prospect of regular dividend payouts, adding a consistent income stream.
Reducing debt burden: Issuing capital stock can also allow companies to pay down existing debt. This can then result in a better credit rating. A higher rating can make future borrowings cheaper, saving money in the long run.
Facilitating acquisitions: A company’s stock may be used as payment for acquisitions. Instead of paying in cash, they can offer shares, thus preserving their cash reserves.
Limitations of capital stocks
- The control of current shareholders is diluted when new shares are issued. While this helps to raise funds, it also means original owners have less say in company matters.
- Unlike interest on loans, dividends are not tax-deductible for companies. This makes them a costlier option for generating capital.
- Issuing shares is a legally complex procedure. It involves adhering to regulations, which often results in significant legal costs.
- For significant business decisions, shareholder approval becomes mandatory. This can be unmanageable if shareholders have differing opinions, leading to delays or even roadblocks.
- Companies must pay dividends to preferred shareholders first, adding financial stress. Especially if revenues are low, meeting these obligations can be tough.
Bottomline
Capital stock is essential in corporate finance and investment. Whether you are dealing with common or preferred shares, it is important to comprehend their distinct characteristics. The risks, rights, and potential rewards vary, so it is crucial to make informed decisions.
