Owner’s Equity: Balance Sheet Components Part 3
This is part 3 of the 3 part post. To learn more check the links below:
What is owner’s equity?
Owner’s Equity refers to the capital of the company. The capital is comprised of the total investments made by business owners. Through the investment, owners expect future profits. The amount of investments determines an investor’s share from the profits. It also determined whether a business owner gets a chair in the board. Having a chair in the board allows investors to have a say in major business decisions and how a business is run.
Common Stock (money obtained from owners)
The amount initially collected from the investors of the business is considered the capital or common stock. The amount of investments determines the amount of dividend every shareholder receives. It should be noted that not all net profit (after tax) is paid as dividend. This may be different from country to country. In Iran, a regular %5 legal reserve is mandatory. The business is also obligated to pay at least %10 of the profit as dividend. The rest is decided in the annual general meeting by the board of directors. This is the case for companies where there are many investors involved. If the company is made through partnership, there may be less formalities involved.
Additional Paid-in Capital (money obtained from owners)
If the business requires to increase capital, one way is to ask the shareholders. In order to raise the capital, an extraordinary general meeting needs to be held. At the meeting, the rationale behind the increase is discussed and if the board of directors finds it plausible, the formal process begins. The company is responsible to inform current shareholders and have their answers before they take any other actions. The reason is that shareholders have the right to invest first. They may wish to keep their ownership percentage of the business. Another reason is that it directly affects the management of the business.
When a company makes a profit, it is obligated to divide that profit among its shareholders. According to the law in Iran, at least %10 of the profit must be paid as dividend. In case the board agrees, the rest can be retained. Retained earnings are important to business since they are the easiest type of financing. In case there is need for a more investment, a capital raise can be made from retained earnings.
According to the Iran commerce law, every company must hold a reserve from its profits. A business is obligated to retain %5 of the profits as legal reserve until it is equal to one tenth of the capital. When the reserve one tenth of the capital, adding to the legal reserve becomes optional. It should be noted that a capital increase cannot be made using the legal reserve.
Just as the investors are the first people to trust the business with their money, they can continue to do so, if the business proves to be profitable. A capital raise from the retained earnings or additional paid-in capital is the safest way for an increase. They can financially support future projects of the business leading to expansion.