Stocks and Securities

What are Stocks and Securities?

Stocks or securities are generic terms for instruments of ownership such as shares., and for instruments of lending like bonds and debentures, which are issued publicly. Just as a share represents the smallest unit of ownership, a debenture or a bond represents the smallest unit of lending. Shares and debentures maybe of many different kinds.

Different Types of Stocks

What are Ordinary Shares?

An ordinary share represents the form of fractional ownership in which a shareholder (one who holds ordinary shares), as a fractional owner, undertakes the usual entrepreneurial risk associated with a business venture. This risk has several dimensions. In a business, an ordinary shareholder generally receives dividends out of operating surplus. This surplus is the residual from the revenue, after subtracting all operating expenses, the interest charges on all borrowings, various taxes, and dividends due to non-ordinary shareholders.

Various economic factors, government policies, market conditions, the labor situation, management efficiency, etc. may affect revenues, expenses, interest, taxes, etc. in such a way that in any given period, there may or may not be adequate surplus left for ordinary shareholders.

Even when a business is on the verge of closing, all other stakeholders, such as employees, creditors, lenders, government, preference shareholders, etc. must be paid their claims first and only the residual can be shared by the ordinary shareholders. For various reasons, this may or may not be enough for the ordinary shareholders to get back thier investment. Thus during the life as well as closure of a business, the ordinary shareholders are exposed to the highest risk. If they are favored with luck and good times a big residual surplus may accrue to them but if not, they may suffer a loss. It is this possibility of variation in their earnings, which constitutes the entrepreneurial risk and since they undertake this risk, they expect to be reasonably compensated for it in the long run through the higher earnings.

In addition, this entrepreneurial risk entitles them to a voting right in proportion to the number of shares held by them. They may exercise this right to suitably shape the affairs of the company.

What are Preference Shares?

Preference shares differ from ordinary shares in some significant ways. In the payment of dividends during the life of the business, as well as in sharing the residual dividend upon the event of a company's termination, a preference shareholder gets preference over the ordinary shareholder and receives his dues first. Thus, the preference shareholders assumed a lower risk and it is therefore reasonable that in the long run they should normally expect to earn less than ordinary shareholders.

Usually, the rate of dividend for preference shares is fixed at the time of issue. Alternatively, a prefererence shareholder may be guaranteed a minimum fixed dividend on the share with an additional variable component depending upon the extent of profits made in a given year. Preference shares that entitle the holders to receive this additional variable component are called participative while those that do not are known as non-participative preference shares. In addition, preference shares may be cumulative or non-cumulative.

In the case of cumulative preference shares, if the dividend is not paid in a particular year due to insufficient profit, it is cumulatively made good in the following year or years, thus providing the shareholders an extra assurance on their dividend earnings. A non-cumulative preference share, on the other hand, does not provide for any such assurance and is therefore riskier. Again a preference share may or may not have voting rights.

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