What is capital stock?
Capital stock refers to the number of shares that a company is allowed to issue under its corporate charter. It includes common stock as well as preferred stock. Corporations raise money for purposes such as expanding or re-investing by selling a certain percentage of their ownership to the public in the form of stocks. Those who purchase these stocks see them as a mode of investment because stock owners are entitled to receive a portion of the business’s yearly profit in the form of dividends. The value of the dividend received every year depends on the number of stocks owned by a person and the financial performance of the company or corporation.
Adding the face value of a corporation’s preferred and common stocks is what gives us the value of its capital stock. Whereas every corporation in the United States issues common stocks, preferred stocks are issued by only a few. Before moving on, let’s understand the difference between these two.
What is the difference between common stock and preferred stock?
These are the types of stocks that not only allow investors to enjoy a share in the company’s profit but also give them the right to vote for a board of their choice. The elected board members then look after matters related to the company and take important managerial decisions.
The downside to purchasing common stock is that the value of dividends received may fluctuate every year, depending upon the company’s growth and annual performance. However, common stock is still more popular amongst investors.
Preferred stock has its pros and cons. Stockholders are entitled to receive a fixed amount as a dividend every year. Thus, they are not affected by a decline in the corporation’s profit, unlike common stockholders. Also, in case of negative events such as bankruptcy, preferred stockholders are given priority in terms of payment. Furthermore, these stocks are convertible to common stocks, but the opposite is not possible.
However, owners of preferred stock have no voting rights and they do not receive any additional dividend even if the company performs exceptionally well in a particular year.
Which option should be invested in?
This decision lies solely with the investor. S/he must take into account the advantages and disadvantages of both types of stocks and judge which one better aligns with his/her objectives.
Authorized capital stock vs. outstanding capital stock
When answering the question “what is capital stock?” We discussed that it is the total number of shares (common plus preferred) which a corporation is authorized to issue. However, an important consideration here is that the corporation or company might not release the maximum number of stocks it is permitted to sell. Hence, there may be a difference between the quantity allowed and the number of shares or stocks issued. This gives rise to the terms authorized stock and outstanding stock.
Source: Authorized stock
The number of stocks that a company is legally allowed to issue is referred to as its authorized capital stock.
Stocks that are issued to the public and capital has been raised against them are referred to as outstanding capital stocks.
One of the benefits of issuing more capital stock from the authorized limit is that it allows the corporation to gather more money without having to take a loan or pay interest. The drawback is that a greater percentage of the ownership is transferred to others. The amount generated via the sale of stocks is reported in the company’s balance sheet as “paid-in capital”. It is recorded in the section “stockholders’ equity”.
Let’s say, a corporation issues 8 million stocks and each stock has a face value of $1. The paid-in capital would therefore be $8 million. However, if the sale price is more than the face value, the excess amount received as revenue would be recorded as “additional paid-in capital” under the section “stockholder’s equity” in the balance sheet.
How to calculate outstanding capital stock?
Let’s look at an example to understand how to calculate outstanding or issued capital stock.
Suppose that a corporation has issued 4000 common stocks with a face value of $10 each, and it has also issued 2000 preferred stocks that have a face value of $50 each.
Paid-in-capital from common stock= 4000*10= $40,000
Paid-in-capital from preferred stock= 2000*50=$100,000
Thus, the value of a corporation’s outstanding capital stock would be equal to 40,000+100,000=$140,000
Can outstanding stock be repurchased?
A company/corporation can buy back the capital stock it has issued. Shares that were previously outstanding but have now been purchased back are referred to as Treasury stocks.
What is capital stock? – An alternate definition
The meaning of capital stock differs in accounting and economics. While we have discussed the accounting connotation in detail, let’s discuss the term from an economist’s point of view. Assets facilitating the production process such as plant and equipment which do not get consumed during the process are referred to as capital stock in economics. However, the definition has recently been expanded to include social capital and human capital as well.
Human capital refers to skills and talent whereas social capital means the relationships that are created as a result of interacting with each other during the process.
Now that you know the dual meaning of capital stock, it is you who will have to identify in which sense the term is being used during a conversation. Taking the context into account would help in figuring this out.
In accounting, capital stock reflects how much a company would have to rely on external debt. The fewer shares it is allowed to issue, the more it would have to borrow to fulfill its financing needs. However, taking a loan is not necessarily an indicator of poor financial performance. The right mix of equity and debt can do wonders for an organization but what is right for one corporation might not be so for another. Therefore, decisions must be taken after scrutiny of the financial statements and consideration of other factors specific to the business.