This article will provide an explanation of what ‘capital stock’ is. It will also explain the shareholder’s equity section of a balance sheet and what separates ‘capital stock’ from ‘treasury stock.’
What is Capital Stock?
‘Capital stock’ is the number of customary and preferable shares that a company has the authorization to issue. This is in accordance with its corporate contract. The amount that the corporation receives when it distributes portions of its capital stock goes into the shareholders’ equity section of the balance sheet. Firms are able to issue more capital stock over time. Alternatively, they can purchase back shares that shareholders are currently in possession of.
For context, shareholder equity (SE) is a corporation’s owners’ residual claim following the payment of debts. Equity is the equivalent of a firm’s total assets minus the total amount of its liabilities. Equity resides on a company’s balance sheet. It’s one of the most common financial metrics that analysts use as a way to gauge a company’s financial health. Shareholder equity is also representative of a company’s overall net or book value.
The very act of issuing capital stock could provide positive impacts on a corporation’s bottom line. With it, they can potentially raise money without provoking a debt burden and any interest charges in association with it.
There are a few notable drawbacks concerning this concept. The primary aspect of these shortcomings is that the company would be relinquishing more of its equity. Furthermore, it would greatly diminish the value of each outstanding share, which are shares that investors issue.
In order to find the value of capital stock (a.k.a. capital), you need to use the following equation:
Capital Stock = Number of shares issued x Par Value per share
Let’s say, for example, a company issues 1,000 shares at a price of $7 per share. This would mean that the capital stock value would be $7,000.
Something that is important to note is that par value is a set dollar amount. Specifically, one that is assigned to each common share. Any amount that’s above the par that the investors pay goes into the accounting books under additional paid-in capital.
The total amount of capital stock should never be more than the amount of authorized stock.
Breaking it down
Only the company can issue capital stock and it is the maximum number of shares that can be outstanding. It is a way for a corporation to raise capital as a means to evolve their business. Investors who seek price appreciation and dividends can purchase the stock. Alternatively, one can exchange stocks for assets, like equipment for properly operating their business.
Before we move forward, let’s briefly explain what outstanding shares are. They refer to a company’s stock that shareholders currently hold. This includes share blocks in possession of institutional investors and restricted shares that the company’s officers and insiders own. Outstanding shares exist on a company’s balance sheet under the heading “Capital Stock.” The number of outstanding shares helps calculate key metrics, like a company’s market capitalization. It also computes both the earnings per share (EPS) and cash flow per share (CFPS). A company’s outstanding shares are not immovable and may change erratically over time.
The number of outstanding shares isn’t necessarily equal to the number of available or authorized shares that the company distributes. A company is able to change this number by way of voting to amend its charter. This usually implies that they plan on issuing stock in order to raise additional capital.
The amount that a company will receive from distributing capital stock will be capital contributions from investors. In addition, the amount is put into the stockholder’s equity section of the balance sheet as documentation.
The shareholder’s equity section
The shareholders’ equity section of the balance sheet consists of three types of account balances:
- Common stock
- Additional paid-in capital
- Retained earnings
The common stock balance is computed as the nominal/par value of the common stock multiplied by the common stock shares outstanding amount. A company’s stock’s nominal value is an arbitrary value whose assignment is for the purpose of a balance sheet. To elaborate, it’s for when the company is issuing share capital and is typically $1 or less. It has absolutely no connection to the market price.
Let’s say that a company acquires authorization to raise $5 million and its stock has a par value of $1. It could potentially issue and sell for roughly 5 million shares of stock. The primary distinction between the par and the sale price of a stock may be critical. However, it’s not technically an inclusion in share capital or subject to capping by authorized capital limits. Therefore, should the stock sell for $10, then $5 million will officially be equity capital on record. Meanwhile, $45 million will be additionally paid-in capital.
Preferred stock is first on the list in the shareholders’ equity section of the balance sheet. This is due to its owners receiving dividends before the owners of common stock. Furthermore, they hold a substantial preference during liquidation. Its par value is different from the common stock, and oftentimes it’s indicative of the initial selling price per share. This is a method for calculating its dividend payments.
The total par value equates to the number of preferred stock shares outstanding times the par value per share. Hypothetically, let’s say a company has 1 million shares of preferred stock at $20 par value per share. If that’s the case, then it will report a par value of $20 million.
Advantages & Disadvantages
An argument can be made there are an equal amount of benefits and drawbacks to selling capital stock. Probably the biggest advantage is that companies don’t need to take out debt in order to fund new projects. If a company needs extra money to grow, they can sell capital stock instead of taking out a loan. This way, they will not have to pay back with interest. An additional advantage is that it allows them to make more money than if they had taken out a loan.
We briefly touched upon the drawbacks earlier, but now we will provide a bit more information. By selling capital stock to investors, a company will basically give up a portion of its equity. To put simply, the more capital stock distribution, the more the value of each share dilutes. With the potential benefits comes the probability of the distribution backfiring on the company later on down the line.
Treasury: what’s the difference?
If you are familiar with terms concerning investments and stocks, you likely have come across ‘treasury stock.’ Capital stock and treasury stock evidently illustrate two very different types of a company’s shares.
Capital stock is the total amount of shares a company is able to distribute. Treasury stock, on the other hand, is the total number of shares that a company holds in its treasury. In essence, treasury stock is capital stock that has been bought back. Either that or is was capital stock that was never able to achieve public distribution.
Treasury stock is a ‘contra account’ that the shareholder’s equity section of the balance sheet records. It is indicative of the number of shares that the open market repurchases. Because of this, it lessens shareholder’s equity by the amount paid for the stock. Not only does it not issue dividends and isn’t in EPS calculations, but treasury shares also don’t possess voting rights. The treasury stock amount cannot exceed the maximum capacity of total capitalization that a nation’s regulatory body specifies.
Investopedia editor, Will Kenton, explains treasury shares’ overall effect on the balance sheet:
“When a company raises cash by issuing stock, the equity portion of the balance sheet shows a positive balance in the common stock and additional paid-in capital (APIC) accounts. The common stock account reflects the par value of the shares, while the APIC account shows the excess value received over the par value.”
There are an array of reasons as to why a company might issue additional capital stock rather than repurchase their shares. Moreover, why they don’t just increase their treasury stock. Regardless of the reasons, the company may end up suffering a short-term monetary advantage in favor of long-term ownership.
To read more about stocks, don’t miss our article: “Stocks and Bonds – A Beginner’s Guide”
All in all, capital stock is a prominent method of business expansion and money-raising. By purchasing stock from a corporation, an investor could potentially reap the plentiful benefits (i.e. dividends). There are risks, of course, but the rewards one could earn are too tempting to ignore.