What is a Capital Reduction?

Capital reduction is a process where publicly held companies will reduce shareholder equity by canceling orders for shares or repurchasing current shares owned by investors. Companies will use this tool to improve their capital structure. A company’s capital structure is the mix of short and long-term debt and equity, which includes both common and preferred shares. Capital reduction helps publicly held companies look more attractive to current shareholders and position their operations for selecting new opportunities to increase profits.

Canceling share orders is not very difficult to accomplish in the securities markets. Public companies will often have a brokerage house that helps process the sales of their securities. These shares will eventually be bought and sold on an open stock market exchange. To cancel stock orders, the company will simply issue a void ticket that negates the original purchase agreement, completing this portion of the capital reduction process. While some amount of paper work is required for this transaction, it may be handled completely by the brokerage house.

Repurchasing shares through capital reduction helps companies improve the outstanding value of shares through basic economic principles. With fewer shares in the open market, the price will rise because the remaining outstanding shares will increase in value. Analysts and other individuals also tend to look favorably on stock repurchasing because it can be an indication that the company is doing well financially and does not need an excessive amount of equity financing to run operations. While cash payments are a common feature of repurchasing stock, a reverse stock split is also possible. Under this process, the company will offer each share holder a new share of stock for every two shares they currently hold. This reduces outstanding shares and provides companies with the ability to set a new price for the shares.

A company’s capital structure and capital reduction plays an important role in determining the organization’s economic wealth. A basic calculation for economic wealth is total assets less total liabilities. The remaining figure — whether positive or negative — is the economic wealth created or lost by the company, respectively. A company with copious amounts of outstanding equity can lower its economic wealth because this money is owed to shareholders. Unless a company offsets shareholder equity by purchasing assets, the money will pay for expenses and be lost in terms of economic wealth. Improving capital structure will also improve a company’s leverage ratio, which can affect its credit score or loan terms from banks and lenders.