What is Legal Capital?

Legal capital is defined as an amount of a firm’s equity that is not allowed to leave the business; an amount that cannot be distributed to shareholders in the form of dividend or as anything else. It is referred as the par value of firm’s common or preferred stock issued to the investors.

Explanation

Par value or face value does not depict the actual value of the stock; on the contrary, it is decided as an arbitrary or nominal amount. Face value is often set at a minimal price in order to protect investors by preventing firms to not issue stocks at a price lower than the par value.

The concept of legal capital was first introduced to produce a reserve for the company’s creditors in the event of default. However, the intent of this capital is effectively negated for those businesses issuing stock having extremely low par values.

When the Firm’s’s share price reduces so much that it comes below par value, the firm Board of Directors can determine the capital of the Firm by defining a stated value to the stock or the amount of owner’s equity that the Firm needs to maintain after buying back its stock and issuing dividends.

Nowadays, companies set very low par values because of which legal capital is so less that it could provide very low protection.

Example

ABC Inc issues 1,00,000 common stock shares at $10 par value, the total value of common stock issued at par equals $10,00,000.

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In this case, if there is any additional amount that ABC Inc receives on issuing the stock, the additional amount will be recorded as additional paid-in capital in excess over par. Let’s assume ABC Inc. receives $15 per share on issuing. Hence, additional paid-in capital comes out to be $5 * 1,00,000, which is $5,00,000, which will be recorded in Journal Entries as follows:

When the Firm’s’s shares are issued, the amount that exceeds the issued value is also recorded in Journal entries as additional paid-in capital account, as mentioned in the above example.

In the above example, ABC Inc cannot announce a dividend in excess of $10,00,000 legal capital determined by the par value of the issued shares.

How to Calculate Legal Capital?

The value of the legal capital of the Firm is the cumulative amount of the par value of all of its stocks.

Hence, if a firm has a par value of $10 with a total of 10,000 shares outstanding, its legal capital would be $100,000.

Legal Capital = $10000 * $10 = $100,000

Importance

This concept was first implemented in order to protect the Firm’s creditors in the event of default or any financial crisis by maintaining a cash reserve, especially for such events.
The concept of this capital can only be applied to issued stocks. For such stocks that have been approved already for issuance but yet to be issued, It cannot be applied.
The value of assets of a firm should always exceed the sum of the value of liabilities it has and the amount of legal capital.i.e., Assets >= Liabilities + Legal Capital
The par value of issuing security depicts some of the full parts of this capital.
Nowadays, companies set very low par values because of which legal capital is so less that it could provide very low protection.

Advantages

This concept provides protection in case of any financial crisis.
It cannot be distributed to the Firm’s’s shareholders by any means.
A firm does not need to pay dividends to the shareholders if doing so would damage its Legal Capital.
A firm does not need to acquire capital shares if such activity could weaken this capital.
This capital ensures that the value of assets of a firm should always exceed the value of liabilities.

Conclusion

Legal capital is an amount of a firm’s equity that is not allowed to leave the business, an amount that cannot be distributed to shareholders in the form of dividends or as anything else. It is referred to as the par value of the Firm’s common or preferred stock issued to the investors.

The concept of this capital is only applicable to stocks that have been issued. It cannot be applied to any stock that is approved for issuance but has not been issued yet to investors.