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Financial Statement Analysis

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Financial Statement Analysis-FIN621
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Lesson-28
TYPES OF BUSINESS ORGANIZATIONS
(Continued)
Book Values of equity/share
Common stockholders equity (for calculating book value) = Total stockholders equity ­
call price or redemption value of preferred stock-dividends in arrears on cumulative preferred stock.
= 2,380,000 ­ (10,000x110) ­ 80,000 (dividend arrears)
= 2,380,000 -1,100,000 ­ 80,000 = 1,200,000
Book value per share common stock = common stockholders equity=1,200,000 =Rs.24
Number of common share
50,000
Book value/share: preferred stock
= call price/redemption value = 1,100,000 = Rs.110
Number of preferred share 10,000
Par value or stated value: It is the amount below which stockholders' equity cannot be
reduced (except by losses or special legal action). A dividend cannot be declared if it would cause the
stockholders' equity to fall below the par value. Par value therefore provides minimum cushion of
equity capital for protection of creditors. It is therefore called legal capital.
Par value, Book value and Market value of Shares are different. Par and Book values of
stock are no indication of its market value. In the case of common stock, it is the investors'
expectations, as to the profitability of future operations, which greatly affects the market value of
common shares, although other factors also play part. Market value of common stock thus shows the
investors' confidence in the management. On the other hand, market price of preferred share varies
inversely with interest rate.
In financial markets, stock is the capital raised by a corporation or joint-stock company through the
issuance and distribution of shares. A person or organization which holds at least a partial share of
stocks is called a shareholder. The aggregate value of a corporation's issued shares is its market
capitalization.
Types of stock
Common stock
Common stock also referred to as common or ordinary shares, are, as the name implies, the most usual
and commonly held form of stock in a corporation. The other type of shares that the public can hold in a
corporation is known as preferred stock. Common stock that has been re-purchased by the corporation is
known as treasury stock and is available for a variety of corporate uses.
Common stock typically has voting rights in corporate decision matters, though perhaps different rights
from preferred stock. In order of priority in a liquidation of a corporation, the owners of common stock
are near the last. Dividends paid to the stockholders must be paid to preferred shares before being paid
to common stock shareholders.
Preferred stock
Preferred stock, sometimes called preferred shares, have priority over common stock in the distribution
of dividends and assets.
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Most preferred shares provide no voting rights in corporate decision matters. However, some preferred
shares have special voting rights to approve certain extraordinary events (such as the issuance of new
shares, or the approval of the acquisition of the company), or to elect directors.
Dual class stock
Dual class stock is shares issued for a single company with varying classes indicating different rights on
voting and dividend payments. Each kind of shares has its own class of shareholders entitling different
rights.
Treasury stock
Treasury stock is shares that have been bought back from public. Treasury Stock is considered issued,
but not outstanding.
Stock Derivatives
A stock derivative is any financial claim which has a value that is dependent on the price of the
underlying stock. Futures and options are the main types of derivatives on stocks. The underlying
security may be a stock index or an individual firm's stock, e.g. single-
stock futures.
Stock futures are contracts where the buyer, or long, takes on the obligation to buy on the contract
maturity date, and the seller, or short takes on the obligation to sell. Stock index futures are generally
not delivered in the usual manner, but by cash settlement.
A stock option is a class of option. Specifically, a call option is the right (not obligation) to buy stock in
the future at a fixed price and a put option is the right (not obligation) to sell stock in the future at a
fixed price. Thus, the value of a stock option changes in reaction to the underlying stock of which it is a
derivative. The most popular method of valuing stock options is the Black Scholes model
Apart from call options granted to employees, most stock options are transferable.
Shareholder
A shareholder (or stockholder) is an individual or company (including a corporation) that legally owns
one or more shares of stock in a joint stock company. Companies listed at the stock market are expected
to strive to enhance shareholder value.
Shareholders are granted special privileges depending on the class of stock, including the right to vote
(usually one vote per share owned) on matters such as elections to the board of directors, the right to
share in distributions of the company's income, the right to purchase new shares issued by the company,
and the right to a company's assets during a liquidation of the company. However, shareholder's rights
to a company's assets are subordinate to the rights of the company's creditors. This means that
shareholders typically receive nothing if a company is liquidated after bankruptcy (if the company had
had enough to pay its creditors, it would not have entered bankruptcy), although a stock may have value
after a bankruptcy if there is the possibility that the debts of the company will be restructured.
Shareholders are considered by some to be a partial subset of stakeholders, which may include anyone
who has a direct or indirect equity interest in the business entity or someone with even a non-pecuniary
interest in a non-profit organization. Thus it might be common to call volunteer contributors to an
association stakeholders, even though they are not shareholders.
Although directors and officers of a company are bound by fiduciary duties to act in the best interest of
the shareholders, the shareholders themselves normally do not have such duties towards each other.
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However, in a few unusual cases, some courts have been willing to imply such a duty between
shareholders. For example, in California, majority shareholders of closely held corporations have a duty
to not destroy the value of the shares held by minority shareholders.
The largest shareholders (in terms of percentages of companies owned) are often mutual funds, and
especially passively managed exchange-traded funds.
Application
The owners of a company may want additional capital to invest in new projects within the company.
They may also simply wish to reduce their holding, freeing up capital for their own private use.
By selling shares they can sell part or all of the company to many part-owners. The purchase of one
share entitles the owner of that share to literally share in the ownership of the company a fraction of the
decision-making power, and potentially a fraction of the profits, which the company may issue as
dividends.
In the common case of a publicly traded corporation, where there may be thousands of shareholders, it
is impractical to have all of them making the daily decisions required to run a company. Thus, the
shareholders will use their shares as votes in the election of members of the board of directors of the
company.
In a typical case, each share constitutes one vote. Corporations may, however, issue different classes of
shares, which may have different voting rights. Owning the majority of the shares allows other
shareholders to be out-voted - effective control rests with the majority shareholder (or shareholders
acting in concert). In this way the original owners of the company often still have control of the
company.
Shareholder rights
Although ownership of 51% of shares does result in 51% ownership of a company, it does not give the
shareholder the right to use a company's building, equipment, materials, or other property. This is
because the company is considered a legal person, thus it owns all its assets itself. This is important in
areas such as insurance, which must be in the name of the company and not the main shareholder.
Even though the board of directors runs the company, the shareholder has some impact on the
company's policy, as the shareholders elect the board of directors. Each shareholder typically has a
percentage of votes equal to the percentage of shares he or she owns. So as long as the shareholders
agree that the management (agent) are performing poorly they can elect a new board of directors which
can then hire a new management team. In practice, however, genuinely contested board elections are
rare. Board candidates are usually nominated by insiders or by the board of the directors themselves,
and a considerable amount of stock is held and voted by insiders.
Owning shares does not mean responsibility for liabilities. If a company goes broke and has to default
on loans, the shareholders are not liable in any way. However, all money obtained by converting assets
into cash will be used to repay loans and other debts first, so that shareholders cannot receive any
money unless and until creditors have been paid (most often the shareholders end up with nothing).
Means of financing
Financing a company through the sale of stock in a company is known as equity financing.
Alternatively, debt financing (for example issuing bonds) can be done to avoid giving up shares of
ownership of the company. Unofficial financing known as trade financing usually provides the major
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part of a company's working capital (day-to-day operational needs). Trade financing is provided by
vendors and suppliers who sell their products to the company at short-term, unsecured credit terms,
usually 30 days. Equity and debt financing are usually used for longer-term investment projects such as
investments in a new factory or a new foreign market. Customer provided financing exists when a
customer pays for services before they are delivered, e.g. subscriptions and insurance.
Trading
A stock exchange is an organization that provides a marketplace for either physical or virtual trading
shares, bonds and warrants and other financial products where investors (represented by stock brokers)
may buy and sell shares of a wide range of companies. A company will usually list its shares by meeting
and maintaining the listing requirements of a particular stock exchange and the different.
Arbitrage Trading
Although it makes sense for some companies to raise capital by offering stock on more than one
exchange, in today's era of electronic trading, there is limited opportunity for private investors to make
profit on pricing discrepancies between one stock exchange and another. As such, arbitrage
opportunities disappear quickly due to the efficient nature of the market.
Buying
There are various methods of buying and financing stocks. The most common means is through a stock
broker. Whether they are a full service or discount broker, they arrange the transfer of stock from a
seller to a buyer. Most trades are actually done through brokers listed with a stock exchange.
There are many different stock brokers from which to choose, such as full service brokers or discount
brokers. The full service brokers usually charge more per trade, but give investment advice or more
personal service; the discount brokers offer little or no investment advice but charge less for trades.
Another type of broker would be a bank or credit union that may have a deal set up with either a full
service or discount broker.
There are other ways of buying stock besides through a broker. One way is directly from the company
itself. If at least one share is owned, most companies will allow the purchase of shares directly from the
company through their investor relations departments. However, the initial share of stock in the
company will have to be obtained through a regular stock broker. Another way to buy stock in
companies is through Direct Public Offerings which are usually sold by the company itself. A direct
public offering is an initial public offering in which the stock is purchased directly from the company,
usually without the aid of brokers.
When it comes to financing a purchase of stocks there are two ways: purchasing stock with money that
is currently in the buyers ownership, or by buying stock on margin. Buying stock on margin means
buying stock with money borrowed against the stocks in the same account. These stocks, or collateral,
guarantee that the buyer can repay the loan; otherwise, the stockbroker has the right to sell the stock
(collateral) to repay the borrowed money. He can sell if the share price drops below the margin
requirement, at least 50% of the value of the stocks in the account. Buying on margin works the same
way as borrowing money to buy a car or a house, using the car or house as collateral. Moreover,
borrowing is not free; the broker usually charges 8-10% interest.
Selling
Selling stock is procedurally similar to buying stock. Generally, the investor wants to buy low and sell
high, if not in that order (short selling); although a number of reasons may induce an investor to sell at a
loss, e.g., to avoid further loss.
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As with buying a stock, there is a transaction fee for the broker's efforts in arranging the transfer of
stock from a seller to a buyer. This fee can be high or low depending on which type of brokerage,
discount or full service, handles the transaction.
After the transaction has been made, the seller is then entitled to all of the money. An important part of
selling is keeping track of the earnings. Importantly, on selling the stock, in jurisdictions that have them,
capital gains taxes will have to be paid on the additional proceeds, if any, that are in excess of the cost
basis.
==Stock price fluctuations The price of a stock fluctuates fundamentally due to the theory of supply and
demand. Like all commodities in the market, the price of a stock is directly proportional to the demand.
However, there are many factors on basis of which the demand for a particular stock may increase or
decrease. These factors are studied using methods of fundamental analysis and technical analysis to
predict the changes in the stock price.
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