A company can Buy Back its own shares or other specified securities out of three sources:
- Free reserves
- Securities premium account
- Proceeds of an earlier issue of shares or other specified securities. [Section 77A(l), The Company’s Act 1956].
Buy back of any kind of shares is not allowed out of the proceeds of any earlier issue of the same kinds of shares.
1. Free reserve
The term free reserve has been defined to carry same meaning as has been assigned in clause (b) of Explanation to section 372A of The Company’s Act 1956. For the purpose of section 372A the term ‘free reserve’ has been defined as those reserves which as per the latest audited balance sheet are free for distribution as dividend and it includes balance of securities premium account. Free reserve means the balance in the share premium account, capital and debenture redemption reserves shown or published in the balance sheet of the company and created by appropriation out of the profits of the company.
2. Securities premium Account
Securities Premium Account is a broader term than Share Premium Account. Share Premium account represents only premium on issue of equity and preference shares, whereas securities premium account represents premium on issue of debentures, bonds and other financial instruments.
3. Proceeds of an earlier issue
Buy back of shares of any kind is not allowed out of fresh issue of shares of the same kind. If it were so, it would frustrate the very purpose of buy back. Fresh issue of equity shares for buying equity makes no financial sense. However, financial logic of buy back could very well be served if preference shares are issued and proceeds are used for buying back equity shares.
- Preference shares carry fixed rate of dividend. Also they are easy to market.
- Preference shares may give better yield to the investor than after tax yield on loan or debentures. At the same time it is possible to lever the capital structure by slimming the dividend paying equity.
That apart buy back of shares is allowed utilizing proceeds of an earlier issue. Proceeds of an earlier issue is an unqualified term. Any issue means any issue of hybrid instruments, debentures, bonds, secured and unsecured loans etc. Thus buy back of equity shares is allowed byissue of any pure or hybrid debt instruments.
Then appropriate source of buy back should be the following if the intention is to swap equity for debt or fixed income bearing instruments:
- Issue of debentures;
- Issue of loans.
Buy Back sourcing caution
While approving the buy back resolution the following points should be carefully scrutinized as regards cash flow linkage of free reserve and securities premium account as they are not necessarily represented by free cash:
- How much of the free reserve and securities premium account are readily available in the form of free cash?
- Whether owned investments in current assets are released for buy back? If so, its impact on current ratio?
- Whether non-trade investments will be disposed to generate free cash? If yes, what is the possible profit/loss?
- If trade investments are proposed to be sold, what is the possible adverse impact on operating activities?
- If any fixed assets are sold, whether it has been intended to reduce the scale of operation of the company