Give me some sunshine; give me some capital

April 9, 2024

My 20-year-old cousin took a fancy to the stock market recently. I would like to take credit for his excitement, given my employment at Zerodha, but I am aware he is just joining the trading wagon with his friends and social media connections.

I am glad that he is curious about concepts. He asks me questions and patiently listens when I try to answer them. Last week, he asked me, “Vodafone Idea wants to raise preference share capital. And for that, it has increased its authorized capital. Is it mandatory to increase authorized capital every time preference shares are issued?” I was thrown off initially, but here is how I tried explaining capital to him.

Firstly, they are raising equity capital through a preferential allotment, and not preference shares. A preferential allotment allows a public company to issue more shares to a limited group and avoid the hassle of raising funds from the public. And increasing the authorized capital is not always a prerequisite. Let’s break it down.

Suppose you want to start an online fast-fashion business. You will need money for it. Whatever money you invest in this business is capital. 

Let’s say you put Rs. 1 Cr of your own. This is equity capital. If you get a bank to lend Rs. 50 lakh to your business, it is debt capital. The total capital in your business is Rs. 1.5 Cr.

Here, we classified capital based on its source. Simply put, the capital that comes from the owners of the business is called equity. The capital that a business borrows is called debt.

You can borrow money in the form of loans from banks or financial institutions. You could also issue bonds and debentures to raise funds from the public.

There is technically no limit to how much debt capital you can put into your business, but there are limits to equity. Don’t worry; you can decide on these limits for your business. But you must stick to those limits. Here is how it works.

When registering your company, you must declare the amount of authorized capital to the registrar. It is the maximum amount of equity capital that your company will be allowed to raise. The amount of equity capital you actually invest in the company is called Paid-up capital.

In the case of your imaginary fast-fashion business, you could have declared an authorized capital of Rs. 5 Cr. The Rs. 1 Cr you actually invested is your paid-up capital. Why this difference? If, in the future, you wish to add more capital to the business, you can add up to Rs. 4 Cr without going through any formalities with the registrar.

Of course, if you want to increase your equity capital to more than Rs. 5 Cr, you must file for an increase in authorized capital with the registrar. Having a larger authorized capital limit is wiser than the planned paid-up capital.

VIL had almost Rs. 49,000 Cr as its equity share capital as of September 2023, while its authorized share capital was Rs. 75,000 Cr. The authorized capital declared with the registrar further has sub-limits with respect to the amount to be raised in common or preference equity ( I will explain this soon). VIL raised its authorized capital of Rs. 75,000 Cr (Rs. 70,000 Cr common and Rs. 5,000 Cr preference shares) to Rs. 1,00,000 Cr (Rs. 95,000 Cr common and Rs. 5,000 Cr preference shares).

If you are running a public company, you must also deal with issued and subscribed capital. Let’s say your fast-fashion business is doing well, and you would like to take it public and grow in scale. You want to raise Rs. 3 Cr.

The existing capital of Rs. 1 Cr and Rs. 3 Cr from the public will take the total capital to Rs. 4 Cr, which is within the authorized capital limit.

So, you solicit investors to buy your company shares worth Rs. 3 Cr. This is your issued capital. Investors placed bids for shares worth Rs. 2.8 Cr only. This became your subscribed capital. When the time to pay for the bids came, some investors could not pay up. So, you received only Rs. 2.7 Cr, which became your paid-up capital.

However, issued, subscribed, and paid-up capital amounts are mostly the same nowadays. You will see how IPO issues get applications multiple times over their issued capital. These applications are accepted for a fraction of what they had bid so that all investors can get a pie. The rest of the applications are rejected. Since applications were more than issued capital, you can safely say that the subscribed capital is the same as issued capital.

Moreover, IPO applications are supported by blocked funds in investors’ bank accounts. Therefore, investors will also pay up what they had subscribed for. In total, paid-up capital also then equals subscribed and issued capital.

Finally, how you use capital, both equity and debt, shows the next level of classification – let’s call it classification on the basis of use. The money you spend on long-term fixed assets such as land, buildings, and machinery is the fixed capital. You don’t spend on buying these assets every year; you expect to use them over multiple years. 

The money you spend on buying raw materials or paying salaries, rent, energy bills, website maintenance, transport, etc, is called working capital. These expenses are recurring in nature. You have to pay for them almost every month. Working capital ideally must rotate – the money you get from this month’s sales should be able to pay for next month’s raw materials, rent, salaries, interest payments, etc, apart from generating profits.

The profits are added to the equity capital. You might also take a part of the profit out of the business as a dividend payment for yourself. The part of the profit that you retained in the business will add to the equity.

You include interest payments in expenses while arriving at the profit. But you also have to pay back the borrowed money, and not just the interest. You may have built up enough cash reserves by retaining profit in the business to be able to repay the borrowings partially or fully. You can use this cash to pay back the debt. That way, the total capital in the business will come down. 

Basically, working capital should generate enough business to:

  1. Continue funding the operations
  2. Grow equity by adding profits
  3. Reduce debt by paying back the debt

Of course, if you can see that the business can grow more by adding more fixed or working capital, you will add more capital by way of equity or even debt.

We know that equity capital could be common equity and/or preference equity. Common shares represent the equity capital we generally understand – they represent part ownership in the company, come with voting rights, and are entitled to dividends. Preference shares also represent ownership in the company but usually do not have any voting rights. Moreover, preference shares are entitled to a fixed dividend every year. 

Preference shareowners must be given dividends before a dividend is declared for common shareholders. If, however, the business were to suffer losses, preference shares might not get dividends, just like common shares. Simply put, preference shares give debt-like returns but carry equity-like risk.

A tl;dr summary, as my cousin would have preferred this blog to be, would be that capital can be classified based on source, use, and equity issuance. Sources of capital are equity and debt. Uses of capital are fixed and working. Equity can be common and preferred. Equity issuance is limited by authorized capital. Actual equity issued, subscribed, and paid up can be equal to or less than authorized capital.

Content, Zerodha Varsity

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