It takes money to make money. And while this may be an evergreen maxim for businesses, raising money for capital investments brings its own set of challenges. Yes, you need to be able to raise money to pay your team, buy new plant and equipment, or invest in marketing campaigns. But you also need to box clever when it comes to raising this capital. Business loans are readily available, but the repayments and interest rates can put a squeeze on your cash flow for years to come.
If you run a publicly traded company, capital stocks can be a useful way to raise funds without having to take on more debt. Here, we’ll take a close look at capital stocks while providing some illustrative examples.
Capital stock explained
Capital stock is issued by companies to raise capital. It is usually issued when companies are trying to fund their growth. They are made up of a combination of preferred and common stock. These are often sold to investors, who may benefit from dividend payments and strong appreciation as the business grows. However, they can also be exchanged for assets which, in turn, can help to facilitate the company’s growth.
Shares issued to investors are classed as outstanding shares. However, there may be a disparity between these and the number of authorised shares. The number of authorised shares is the maximum number that the company is legally allowed to issue.
Companies record the income from capital stock on their balance sheets under the shareholder equity section. It is reported as paid-in capital, and additional paid-in capital. It is calculated by multiplying the par value of the stocks by the number of shares outstanding. A nominal value may be applied to the stock when the company is in the process of issuing shares. This is a placeholder figure and is usually an arbitrary amount (typically £1 or less). The nominal value of shares has no bearing on their market price.
Advantages of capital stock
The primary example of common stock is that it enables businesses to raise money to fuel growth or facilitate operations without the need to take on additional debts. The more debts a company accumulates, the more of their profit margins they sacrifice to interest rates. These may impede the company’s liquidity, which in turn can stymie the company’s growth.
By issuing capital stocks, businesses open up a potential revenue stream that does not add to their debt burden. Capital stocks are also advantageous to investors, as they allow the investor to form a vital part of the company’s growth, with great potential for appreciation and healthy dividends.
Disadvantages of capital stock
While capital stock can be advantageous for SMEs with growth mindsets, they also have their caveats. The more shares a company issues, the more equity they relinquish to outsiders. Issuing a large number of shares also dilutes the value of each outstanding share.
Example of capital stock
Hopefully, this guide has given you an understanding of capital stocks and how they work. Let’s look at an illustrative example to show how they would be reported in an accounting period.
Let’s say your company is authorised to raise £5 million to fund future growth. Your stock has a par value of 50p, meaning that you can issue and sell up to 10 million shares of stock to raise this £5 million. You would log the difference between the par value and the sale price of these shares under shareholders’ equity on your balance sheet as additional paid-in capital.
If the stock sells for £5, you would record £5 million as paid-in capital, with £45 million recorded as additional paid-in capital.
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