Understanding stock market terminology allows investors to make appropriate, intelligent decisions. As it relates to company stocks, knowing the difference between authorized shares and outstanding shares is important in correctly calculating important ratios that speak to the financial stability of a company.
Authorized shares are defined as those available to issue to investors, and the total number is established in a company's legal formation documents, known as the articles of incorporation. There is no limit as to the total number of shares that can be authorized within these documents for a larger company, while smaller companies that do not plan to expand or that have a set number of shareholders are limited to the number of authorized shares that they designate. For a company that does not have an authorized shares restriction, the articles of incorporation may authorize one share or millions of shares. The number of authorized shares can be changed by way of a vote from shareholders, typically during the annual shareholder meeting.
Shares that are issued or sold to investors from the available number of authorized shares are known as outstanding shares. The number of outstanding shares is set by the investment bank that implements a company’s initial public offering (IPO), but the number can change. A secondary stock market offering can increase the number of outstanding shares, as can payment of employee stock options. Outstanding shares decrease when a company repurchases its own stock. The total number of outstanding shares cannot be greater than the total number of authorized shares as laid out in a company's articles of incorporation.
For investors, understanding the difference between authorized and outstanding shares allows for more accurate calculations of financial ratios. For instance, using outstanding shares to determine earnings per share (EPS) could result in inflated gains, while using authorized shares may drastically offset a realized loss. Investors should have a strong understanding of these underlying terms in order to make correct calculations on a company’s financial stability and performance.