Common Stock: Equity Shares and Ordinary Shares in Long-term Instruments
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Long-term Instruments: Common Stock (Equity Shares and Ordinary Shares)
Securities with maturity period more than a year are known as long-term financial instruments.
There are three main long-term financial instruments; they are:
Common stocks (equity shares or ordinary shares)
Debt capital (bonds, debentures or long-term loan)
Preference stocks (preference shares)
Common Stock (Equity Shares and Ordinary Shares)
Common stock or equity share is an ownership document.
It is issued by a limited company (joint Stock Company) to raise equity capital.
Every limited company is established with the help of equity shares.
In other words no equity shares, no limited company.
Total or authorized capital of the company is divided into small fractions.
These fractions are called shares.
The person who purchases shares of the company is known shareholder.
Shares are transferable to other persons and companies.
Common stock is also called ordinary share, common share or equity share.
The dividend rates on these shares are not pre-determined.
Equity shareholders can get dividend only after interest on debentures and dividend on preference shares is paid.
At the time of liquidation (winding up), equity shareholders get capital only after paying all the debts and preference share capital.
Therefore, common shareholders have residual right on income and capital of the company.
(A) Importance of equity shares to the company
No need to pay dividend when company incur loss.
No need to refund money to equity shareholders, equity share capital can be used by the company till the firm remains in existence.
The directors are elected by equity shareholders for effective management.
(B) Importance of equity shares to the shareholders
Every shareholder has a right of voting to elect the directors of the company.
If company earns more/high profit, equity shareholders can enjoy it.
Equity shareholders can easily sell or transfer the ownership to other investors/organizations.
Features of Common Stock
The main features of common stock are as follows:
Permanent capital
Equity share capital remains permanently with the company.
It is returned only when the company is wound up.
Therefore, equity shareholders are the permanent investors.
Owners
Equity shareholders are the actual owners of the company.
They invest initial capital.
They bear the highest risk.
Transferable
Equity shares are transferable.
Ownership of equity shares can be transferred with or without consideration to other shareholders.
Dividend
Equity shareholders do not get fixed rate of dividend.
Dividend payable to equity shareholders is an appropriation of profit.
If company does not earn profit any year, equity shareholders may not get dividend.
Voting right
Equity shareholders have voting right according to their shares.
Equity shareholders have the legal power to elect board of directors (BOD).
They can replace them if the board fails to protect interest of the shareholders.
Equity shareholders have the right to control the affairs of the company.
Limited liabilities
Equity shareholders have limited liabilities upto their investment.
If company bears heavy loss, equity shareholders do not need to invest more than their shares investment.
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Advantages of Common Stock
The advantages of common stock to issuer and investor are as follows:
(A) From the view point of company (issuer)
Minimum restrictions
The firm has minimum restrictions from common stock financing.
The firm has no legal obligation to pay dividend.
The company has to pay a dividend to the common stock if it makes earnings.
Maturity
There is no fixed maturity period for common stock.
Hence, it reduces the obligation of repayment in future.
Sold easily
Common stocks can be sold easily from the primary market.
It is attractive to certain investor due to more expected return than in preferred stock and bond.
Increasing in borrowing capacity
Common stock helps to increase the future borrowing capacity of the firm.
If the equity capital is more, the financial manager receives flexibility.
It becomes easier to borrow fund in future.
(B) From the view point of investors
More income
The common stockholders are residual claimers.
Hence, they receive all portion of profit left after making all other payments.
Bonus share is also received in common stock.
Participation in management
Common stockholders can participate in management using their voting rights.
Thus, they can control the company.
They elect board of directors for their benefit.
Best investment
It is said that higher the risk higher the gain.
Investors who take risk by investing in equity shares are able to take huge benefit from it.
Ownership
Common stockholders are the real owners of the company.
They have voting rights.
Therefore, they have the right of ownership.
While buying the common stock, the investor receives share certificate at which the number of shares and the price of share are mentioned.
Disadvantages of Common Stock
The main disadvantages of common stock are as follows:
(A) From the view point of company (issuer)
High cost
Common stock is an expensive source of long-term finance.
The shareholders expectation of return is generally high.
It needs large flotation costs as underwriting commission, brokerage fee and other expenses.
Heavy dividend
The company has to pay large amount of dividend from profit.
Thus, the company may not be able to maintain different type of funds (reserves) for future investment.
No tax benefit
Common stock dividend is not tax deductible.
In other words, while calculating the taxable income of the firm, the dividend cannot be deducted as expenditure.
Obstacle in management
Equity shareholders have voting rights.
Due to large number of equity shareholders and right on management, they can form group.
Grouping may create obstacle in management and decision making.
Over capitalization
The amount of capital collected from equity capital cannot be refunded easily like debt or preferred stock.
Due to high capital than required, the company may have to face the problem of over capitalization.
We know the fact that idle money earns nothing.
(B) By the view of investor
Irregular income
There is no fixed dividend rate in common stocks.
The income of investors is irregular and uncertain.
There is no legal obligation to provide dividend.
Sometimes, the board of director may decide not to give dividend.
Last priority
Common stockholders have last priority in the liquidation.
In other words, the common stock holders receive what is left after distributing to the preferred stock holders and bond holders.
Loss in capital
The income of the company decreases during periods of recession.
Due to this, the rate of dividend of common stock decreases and market price of common stock also decreases.
Thus, the investors will lose their capital.
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Cost Accounting |
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Rights and Privileges of Common Stockholders
Rights and privilege of shareholder vary from state to state and country to country.
But some common rights are given below:
Right on income and assets
Common stockholders (equity shareholders) have the right on profit of the organization.
Similarly, they have right on remaining fund after paying all liabilities.
Thus equity shareholders have right on income and assets.
Voting right
Every equity shareholder has voting right to elect managing directors.
Each shareholder has one voting right. In the absence of shareholder, proxy vote can be used.
After managing director is elected, he does work in favour of shareholders.
Dividend
Equity shareholder receives dividend on his shares.
Dividend is paid from profit.
If there is loss in any accounting year, shareholders cannot receive dividend.
There is no guarantee of dividend.
Transfer of ownership
Shareholders can transfer their right of shares to other persons/organizations.
The right to transfer of ownership is ordinary.
It can be done with the help of share brokers (secondary market).
Share broker charges fees for this work.
Authority to inspect books and records
Shareholders have authority to inspect books of accounting.
Although all the limited companies publish their financial statements at the end of accounting period yet shareholders can inspect documents at any working time of the company.
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