Treasury Stock: Strategy of Company Behind It l It’s impact on Balance Sheet and 4 limitations

Definition

When a company buys back its shares, it is known as “Treasury Stock” until the company resell or cancel these shares. It is also known Share Repurchase or Share Buyback by the company.

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Treasury stock is not an asset, as it reduces the shareholder’s equity. Usually, companies buy its own shares at a premium than current market price of share. The shareholder’s equity reduces in the company’s balance sheet as a result of buyback process, and company will include the footnote in the balance sheet in relation to buyback. Companies buys its own shares from its retained earnings. Companies balance sheet would not be consider as complete without the notation regarding the reduction of retained earnings due to buyback, thus companies show up treasury stocks in the shareholder’s equity section of balance sheet as a reduction. In India, the treasury stock needs to comply the regulations of SEBI or cancel it, as companies are not allowed to hold it till indefinite time.

Why companies buyback their shares

The irony is that, there is an incomplete information for buyback among many people is – if a company is buying back their shares so it is the clear indication that company is doing well financially and company is assured for its future growth, and there is no need of much homework to analyse fundamentals of company and this is the right time to invest in that company.

But the question here is that “it’s only enough to buy a stock?” Will it not be the same just like the drive blindly and welcome of unfavourable event deliberately?

Click to learn the concept of Debt to capital ratio; ARPU Rate (Average revenue per user); Debt ratio; Debt to equity ratio

Companies can buy back their shares under the specific strategy

1. 1. To meet the internal obligations regarding employee’s stock options which gives a guarantee to employees to buy shares at a discounted price than market price at the same time.
2. To improve the numbers such as increase the ROE (return on equity), EPS (earning per share) and price per earnings ratio (P/E ratio) in case of same earnings.
3. Very rarely, sometimes company decides to go private, as the company and its board of directors don’t want to operate under the eyes of competitors, investors, government, creditors and any other outsiders with the intention of operate under a privacy without much worry.
4. Companies may also use treasury stocks in case of acquisition to payment.
5. Companies may buy back its shares if market is undervalued or share price isn’t performing well, as buying back gives a positive message among investors and market and boost their confidence into company.

𝗔𝗻𝗱, 𝗺𝗼𝘀𝘁 𝗶𝗺𝗽𝗼𝗿𝘁𝗮𝗻𝘁, 𝗱𝗶𝗴𝗴𝗶𝗻𝗴 𝘁𝗵𝗲 𝗰𝗼𝗺𝗽𝗮𝗻𝘆’𝘀 𝗳𝘂𝗻𝗱𝗮𝗺𝗲𝗻𝘁𝗮𝗹𝘀 𝘁𝗼 𝗴𝗲𝘁 𝗲𝘃𝗲𝗿𝘆 𝘀𝗸𝗶𝗻𝗻𝘆 𝗶𝗻𝗳𝗼𝗿𝗺𝗮𝘁𝗶𝗼𝗻 𝗶𝘀 𝘁𝗵𝗲 𝗺𝗲𝗮𝘁-𝗮𝗻𝗱-𝗽𝗼𝘁𝗮𝘁𝗼𝗲𝘀 𝗯𝗲𝗳𝗼𝗿𝗲 𝗶𝗻𝘃𝗲𝘀𝘁𝗶𝗻𝗴.

Example

Let’s say if a hypothetical privately owned company XYZ Private Limited decides to debut on Stock Market. They sold 1 lakh shares at INR 100.00 of per share and becomes public. The earlier XYZ Private Limited now becomes XYZ Limited. The company is doing well and let’s assume that after five years the board of XYZ Limited decides to buy back its 20% shares. The current market price of XYZ Limited’s per share is INR 165.00. Company bought back its 20,000 shares (20% of total number of shares 1 lakh) at INR 33,00,000/- (current market price of shares is 165 multiplied by 20,000 is equal to 33,00,000). These 20 thousands shares are Known as “Treasury Stock” until XYZ Limited cancel or resell these shares.

Impact and Accounting for Treasury Stock

Impact of shares buyback by XYZ Limited in balance sheet

There are several changes caused by the shares buyback –

1. The balance sheet of XYZ Limited will still be in balance, but company’s cash will be decreased by INR 33 lakhs.
2. The buyback reduces the company’s cash, ultimately the retained earnings and total shareholder’s equity will be decreased.
3. The number of outstanding shares of XYZ Limited now is 80 thousand [1,00,000(issued shares) – 20,000(bought)], but total number of issued shares by XYZ Limited will not be changed from its originally issued shares 1 lakh. In simple words, after buyback the total number of outstanding shares of XYZ Limited: 80 thousand and total issued shares: 1 lakh.
4. 4. If company declares any cash dividend, it will only be paid to 80 thousand outstanding shares; company will not pay itself of any amount as dividend for 20 thousand shares, as treasury stock isn’t considered as outstanding shares.

Click to learn Permanent working capital; Net current assets; Working capital; Net working capital

Impact of selling of treasury stock in balance sheet

There are also several changes when company sell its treasury stocks –

1. Shareholder’s equity will be increased by the selling amount of treasury stocks.
2. In the shareholder’s section of company’s balance sheet, the treasury stock amount will be decreased by the cost of selling part of treasury stock.
3. Accounting rules don’t allow to companies to record any amount as profit by selling its own shares. If selling amount of the treasury stock is greater than the cost of that, difference will not be recorded as retained earnings, therefore, company’s income statement will not be impacted. Company should record the difference as a separate account in the balance sheet, such as – “Paid-in capital in excess of cost, Treasury”.
4. If shares of treasury stock are sold for less than cost, the “Paid-in Capital, Treasury” account is reduced. If this account does not exist or if the account doesn’t have enough to absorb the difference, the “Paid-in Capital in Excess of Par, Common” is reduced. If this account is also not sufficient, Retained Earnings will be reduced.

For example

After some time, company XYZ Limited sells 14 thousand shares out of total 20 thousand shares of treasury stock at INR 190.00 of per share. In this case, company will receive of INR 26,60,000/- (14,000 multiplied by 190) by sell of 14 thousand treasury shares. The cost was INR 23,10,000/- (14,000 multiplied by 165) of the selling part of the treasury stock. So, the difference of INR 3,50,000/- will not be recorded as retained earnings, as its not a profit as per accounting rules.

Limitations of shares buyback (limitations of treasury stock)

1. Reduces the number of outstanding shares.
2. No voting rights.
3. No dividend.
4. No claim on company’s assets in case of company’s liquidation.

अब Balance Sheet को समझना मुश्किल नहीं

Conclusion

When a company buys its own shares from existing shareholders and hold these shares, it is known as “Treasury Stock”. Some companies buys its shares to improve its financial ratios.

Must, Also Read –

1. The Buffett Indicator
2. What is the Historical Cost in Accounting. 5 important differences between Historical Cost Accounting and Fair Value Accounting.

FAQ (Frequently Asked Questions)

Q-1. Is treasury stock allowed in India?

Ans. In India, the treasury stock needs to comply the regulations of SEBI or cancel it, as companies are not allowed to hold treasury stocks till indefinite time.

Q-2. What is the treasury stock?

Ans. When a company buys its own shares from existing shareholders and hold these shares, it is known as “Treasury Stock” until the company resell or cancel these shares.

Q-3. Is treasury stock assets or liabilities?

Ans. Treasury stock is not an asset, and companies record the treasury stock in the stockholder’s equity section of balance sheet.