Capital Stock – What is Capital Stock (Definition and Explanation)

What is Capital Stock?

capital stockCapital stock is the number of common and preferred shares of stock that a company is authorized to issue, as granted in its corporate charter. The amount of money a corporation receives when it issues shares of its stock is reported in the shareholders’ equity section of the balance sheet. Firms can issue more capital stock over time.  They can also buy back shares that have already been issued and are currently owned by shareholders.

Companies need to acquire funds to finance growth and prosperity.  For publicly traded companies, there are a few different ways they can do this. Some companies take out loans with high-interest and borrow the funds to grow.  Others issue capital stock.  This provides debt-free funding in exchange for a percentage of ownership to the investors.

Key Points

  • Capital stock is the total number of common and preferred shares that a company is authorized to issue.
  • The value of outstanding shares is recorded in the shareholders’ equity section of the balance sheet.
  • It should not be confused with outstanding shares.  Capital stock, it is the maximum number of shares that can ever be outstanding.
  • Issuing stock can positively impact a corporation’s bottom line.  It lets them raise money without incurring debt and the associated interest charges.
  • In exchange for issuing stock, the company relinquishes more of its equity and dilutes the value of each outstanding share.

When people invest money in a company in return for a percentage of ownership in that company, they purchase shares of stock. A corporation’s stock, which includes both common and preferred stock, can only be issued by the company.  It is commonly used to raise capital to grow and operate the business. Companies can also issue stock to pay for assets like land, facilities, or equipment. Investors buy stock seeking returns (dividends) and share appreciation. A company is permitted to issue additional capital stock over time, or buy back the shares currently held by shareholders.

Capital stock can be divided into two main subsections. Common stock is typically issued by U.S.-based corporations, while only a small percentage of corporations issue preferred stock. The values of preferred stock and common stock differ and are used to calculate dividend payments.  How capital stock value is reported is dependent upon whether the stock has a stated (par) value. Par value is a set dollar amount assigned to each common share. The dollar amount a corporation receives in exchange for shares of capital stock is reported as paid-in capital balance in the stockholders’ equity section of the company’s balance sheet. Any amount paid by investors above the par value is entered as additional paid-in capital. Preferred stock is listed first because its holders receive prioritization of dividend disbursement and liquidation over common stockholders. The amount of capital stock issued to individual investors determines the percentage of company ownership each investor owns. For example, if there are 20,000 shares of capital stock and an investor owns 10,000 stocks, he owns 50 percent of the company. (Source: indeed.com)

Understanding Capital Stock

Capital stock can only be issued by a company.  It is the maximum number of shares that can ever be outstanding. It is a way for a corporation can raise capital to grow its business without going into debt. The stock issued can be purchased by investors, who seek price appreciation and dividends.  Stock can also be exchanged for assets, like equipment needed for operating the business. The actual number of outstanding shares issued to investors is not necessarily the total number available.  There may well be more shares authorized, but have not yet been issued by the company. A company can change this number by voting to amend its charter.  When this occurs, it often indicates that the company plans to issue stock to raise more capital.

How to Calculate Capital Stock Value

Capital Stock = Number of shares authorized x Par Value per share

Issuing stock can positively impact a corporation’s bottom line.  It lets a company raise money without incurring a debt and associated interest charges. However, by issuing stock, the company would be surrendering more of its equity and diluting the value of each outstanding share. The amount that a company receives from issuing stock is considered to be capital contributions from investors.  It is reported in the stockholder’s equity section of the balance sheet. The shareholders’ equity section of the balance sheet usually lists three account balances:

  1. Common stock
  2. Additional paid-in capital
  3. Retained earnings

Share Premium and Preferred Stock 

The common stock balance is calculated as the nominal or par value of the common stock multiplied by the number of common stock shares outstanding. The nominal value of a company’s stock is an arbitrary value assigned for balance sheet purposes when the company is issuing share capital – and is typically $1 or less. It has no relation to the market price. For example, if a company obtains authorization to raise $5 million and its stock has a par value of $1, it may issue and sell up to 5 million shares of stock. The difference between the par and the sale price of a stock, called the share premium, may be considerable, but it is not technically included in share capital or capped by authorized capital limits. 

So, if the stock sells for $10, $5 million will be recorded as equity capital, while $45 million will be treated as additional paid-in capital.  Preferred stock is listed first in the shareholders’ equity section of the balance sheet, because its owners receive dividends before the owners of common stock, and have preference during liquidation. Its par value is different from the common stock, and sometimes represents the initial selling price per share, which is used to calculate its dividend payments. Total par value equals the number of preferred stock shares outstanding times the par value per share. For example, if a company has 1 million shares of preferred stock at $25 par value per share, it reports a par value of $25 million.  (Source: investopedia.com)

The Corporate Charter Authorizes Capital Stock

A corporate charter is a legal document used to start a corporation.

  • The charter includes the total number of authorized shares of stock.
  • Authorized stock refers to the maximum number of shares that a firm can issue during its existence.
  • Those shares can be either common or preferred stock shares.
  • A business can issue shares over time, as long as the total number of shares does not exceed the authorized amount.
  • A company can only change this number by voting to amend its charter.

Issuing Capital Stock – Advantages

Issuing stock has advantages

  • Growth without debt – The ability to finance new growth without going into debt. Rather than borrowing money (which will show as a liability on the public financial documents), the company can sell capital stock to fund its growth.
  • Large amounts of money can be raised – The amount of capital raised by selling stock may be more than the funding received had the company taken out a loan from a bank (plus, they’re saving on the interest they would have paid on the bank loan).
  • Shareholders participate in the company’s success – Issuing stock allows the company to benefit from the expertise and resources of the qualified business people who are their stockholders. Since these investors own part of the company, they are quite literally invested in the company’s success.  There’s an incentive for them to lend their services and resources to facilitate profitability.

Issuing Capital Stock – Disadvantages

Issuing stock can have drawbacks, as well.

  • Surrendering ownership – By selling capital stock to investors, the company is giving up some of its ownership.
  • Diluting outstanding share numbers and value – The more capital stock the company issues, the more diluted the value of each share becomes.
  • Current owners can eventually lose majority control – As a company continues to raise capital through the issuance of stocks, the owners and founders may, at some point, no longer have majority control.
  • The total number of shares is fixed – The number of shares that can be sold is finite. Eventually, there will be no more ownership in the company to offer to investors.
  • Dividend expense going forward – Often, the company will have to promise to pay dividends as an incentive for investors to provide capital. If a company agrees to pay dividends and then doesn’t pay them out, the company’s reputation and stock price could be negatively affected.

Frequently Asked Questions Related to Capital Stock

What is a corporate charter?  A corporate charter, also known as a “charter” or as “articles of incorporation,” is a legal document that is used to start a corporation. It is filed with the state government of whatever state in which the company incorporates. It details things like a company’s location, whether it will be a profit or nonprofit, its board composition, and its ownership structure. This also is where a company will list the total number of authorized stock they intend to use.

What is treasury stock?  Treasury stock is previously issued shares that a company repurchases from investors. Once a stock is repurchased the company can either cancel it, reissue it, or hold onto it.  Treasury stock is authorized and issued, but not considered outstanding. Incorporated businesses are not legally allowed to own shares of their own stock. Therefore, treasury stock is recorded as a decrease in capital stock on the company’s balance sheet.

What’s the difference between common and preferred stock?  Preferred stockholders have more preference than common stockholders in the event of the company’s liquidation. Preferred stockholders will receive their share of the payout before the common stockholders and they’ll take priority in receiving dividends, as well.

What is par value?  The par value is the minimum value that cannot be used to pay shareholder dividends. This is a government-implemented rule, to which companies responded by setting the par value for their common stock certificates at one cent or less. Par value is not market value. Par value is arbitrary, a value assigned to shares of stock sold by corporations (for those that assign a value at all). Conversely, market value is the real-world value of the price of a stock on the open market. Capital stock gains market value only after the shares that are issued to investors are sold to third parties on the open market.

What is preferred stock?  Holders of preferred stock receive their dividends before common stockholders do. In exchange for this priority, preferred stockholders will typically not be paid more than the stated dividend. For example, a shareholder who holds 100 shares of a company’s 7%, $100-par preferred stock will be paid an annual dividend of $700.  They’ll receive it before common stockholders receive their cash dividend payments for that year. Under most circumstances, the preferred stockholder will never be paid more than $7 per share, no matter much success the company gains.  Preferred stock tends to lose value when the rate of inflation rises. With dividends paid on preferred stock typically remaining at a fixed amount indefinitely, the stock’s market value generally moves in the opposite direction of inflation. If the inflation rate declines, the value of the preferred stock is can increase proportionally, but no higher than the stock’s call price. (Source: indeed.com)

What Do Economists Mean by Capital Stock? 

In economics, the term capital stock is often interchangeable with the terms capital goodsreal capital, or capital assets. By any of these names, capital stock items are already-produced, durable goods, or any non-financial asset that works for the production of goods or services.

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Often, when people have a good idea or invention, they try to patent it before they try to sell it. A patent is useful because it grants exclusive legal rights for the inventor. Also, it lets the inventor decide who else can use the idea or invention.  This legal protection keeps inventors from being ripped off by copy-cat inventions.  However, you do not need a patent to sell your idea or invention. There are ways you can start selling your idea without going through the expensive and time-consuming patent process.

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