What is Capitalization? Over and Under, Causes and Effects

Furthermore, it will be necessary to convince holders of existing bonds to accept new bonds with reduced interest rates in place of their current ones. Rigorous taxation policy of the Government may also result in over-capitalisation. Due to higher tax burden, very little amount is left with the company for dividend distribution among the shareholders at a prevailing rate, which is a symptom of overcapitalisation. Moreover, the company may face shortage of funds for both working capital as well as for financing the renewals and replacements of wornout assets. Consequently, the working efficiency of the company will be decreased, and the prices of its shares will fall. A company is said to be over-capitalised when its earnings are consistently insufficient to yield a fair rate of return on the amount of capitalisation.

When undercapitalization becomes problematic and a business no longer has enough money to operate, it can result in lost opportunity and possible insolvency. Undercapitalized businesses are also at a disadvantage in capturing innovation and growth opportunities. Intentional underfunding is a less common cause of undercapitalization that can lead to significant legal consequences. Some entrepreneurs opt to intentionally minimize the amount of capital they contribute to a business with the expectation of shielding personal assets in the event the business fails or is sued. This can lead to undercapitalization if the amount of contributed capital is less than the business needs to reasonably operate and pay its debts.

Money Market: Meaning, Definition, Features, Importance, Characteristics, Functions

A business may become insolvent if its cost structure is larger than its ability to generate profits and it lacks access to external sources of capital, such as loans or owner contributions. The company may follow a liberal dividend policy and may not retain causes of over capitalisation sufficient funds for self-financing. It is not a prudent policy as it leads to over-capitalization in the long run, when the book value of the shares falls below their real value. (i) Over-capitalisation results in reduced earnings for the company.

• Although it may seem detrimental to a business, there is one advantage to being overcapitalized.
• Similarly, the capital gearing ratio will be low and the current ratio will be high.
• Alongside this, in anticipation of high earnings during boom period there is strong tendency to fix the capitalisation at high figure.
• But when boom conditions cease prices of products decline resulting in lower earnings.
• Consequently, lion share of firm’s income may be swallowed by the lenders who come to the firm’s rescue in eventuality, leaving little income available for the shareholders.

A company may have large secret reserves due to which its profitability is higher. (v) In case of reorganisation, the face value of the equity share might be brought down. (c) A part of the capital is either idle or invested in assets which are not fully utilised. If none of these options is viable, the company may want to seek out a merger or be acquired by another entity. Our writing and editorial staff are a team of experts holding advanced financial designations and have written for most major financial media publications.

Borrowings at Higher Interest Rates:

The face value or the number of equity shares may be reduced in order to rectify over-capitalisation. Sometimes, shareholders may oppose to this proposal but actually their proportionate interest in the equity is not reduced. The amount available due to reorganisation of share capital is utilised for writing off the fictitious assets and other over-valued assets. If a company’s products register a constant decline, it will bring down the profitability of the concern and as a result, returns on capital employed will be reduced which represents over-capitalisation. The management may follow a conservative dividend policy leading to a higher rate of plowing back of profits. Over-capitalisation may be caused in a company if it raises excessive capital than what it can utilise effectively.

• They may also have to pay more in dividends than they can sustain over the long run.
• The articles and research support materials available on this site are educational and are not intended to be investment or tax advice.
• In order to prevent declining trend of income, an over-capitalised concern resorts to increased prices and reduction in quality of its products..
• Sufficient capital is essential to stay in business, avoid bankruptcy and feed growth.
• Degraded earnings would hint towards the instability of business operations which may consequently lead to a downfall of share prices causing a ripple effect.
• Suppose you are the marketing manager of buyer & company ahmedabad , which are technique you will apply in forcasting demand of a products yet to be manufactured .

Since the rate of interest on debentures is fixed, the equity shareholders will get lower dividend in the long-run. It loses investors’ confidence owing to irregularity in dividend declaration caused by reduced earning capacity. Consequently, it has to encounter enormous problems in raising capital from the capital market to cover its developmental and expansion requirements.

Overcapitalization

Thus, the company’s earnings per share is Rs. 10 and return on total capital employed is Rs. 5. Now, if the company reduces the par value of shares by 50% and transfers the same to surplus account, it would result in increase in return on capital by 100%. Despite correct estimate of earnings a company may plunge in state of over-capitalisation if higher capitalisation rate was applied to determine its total capitalisation. For example, a company’s earning was estimated at Rs. 10,000 and the industry average rate of return was fixed at 8 percent. If the future capital requirements are under­estimated by the promoters, the inadequacy of capital is experienced at a later stage.

As a matter of fact, such payments are made out of capital and to cover capital deficiency they take recourse to debt which would further aggravate the crisis. Taxation policy of the Government may also be responsible for company’s over-capitalisation. Due to negative taxation policy firms tax liability increases and is left with small residual income for dividend distribution and retention purposes.

The debentures and bonds should be redeemed to restore parity between the book value of the company and its real value. True reduction of capitalization would be affected if the debt is retired from earnings. If the establishment of a new company or the expansion of an existing concern takes place during the boom period, it may be a victim of overcapitalization. Defective financial planning may lead to excessive issues of shares or debentures. The issue would be superfluous and a constant burden on the earnings of the company. (i) The shares of the company may not be easily marketable because of reduced earnings per share.

Preparations include establishing a rainy-day capital fund and setting up access to credit or additional investment. However, small business owners may be limited in their ability to make additional investments in the business, and credit limits for borrowing may be inadequate. For this reason, undercapitalization can also mean that funds aren’t available for growth or expansion. When a company is undercapitalized, it is unable to pay for its obligations, such as rent, supplies, payroll and debt. Said another way, undercapitalization creates a liquidity problem.

The excess capital also means the company has a higher valuation and can claim a higher price in the event of an acquisition or merger. Additional capital can also be used to fund capital expenditures, such as R&D projects. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. In extreme conditions, the company may choose to merge or be acquired.

How Does Overcapitalization Work?

It means that there are secret reserves in under-capitalized companies. Therefore, if excessive funds have been allocated to the acquisition of goodwill, a lower amount of funds will be available for use. The promoters of a company may issue more than the required number of shares and debentures, and these funds may remain idle. Such funds will not earn a return, whereas investing them may yield a high return. Overcapitalization occurs when funds of a long-term nature (e.g., share capital, debentures, and loans) exceed the amount of optimal capitalization. Shareholders find it difficult to borrow money against the security of their shares.

When a company finds itself in this situation, it may have excess capital or cash on its balance sheet. This cash can earn a nominal rate of return (RoR) and increase the company’s liquidity. Overcapitalization refers to a situation where a company has excessive capital compared to the normal level of investment required for a specific business venture. For example, there may be too much money invested in plant and equipment or other assets that have limited applications. In other words, overcapitalization occurs when a company has more capital than is normally required to carry on a business.

In such cases, companies will have to pay more than what was earned. The situation will result in declining returns and, in turn, overcapitalization. The reduction in the real value of assets will lead to low earnings and overcapitalization.

What is Capitalization?

Higher earnings may encourage competitors to enter into a cut-throat competition amongst themselves. The old debenture holders may agree to take new debentures at a lower rate of interest when the premium is given on new debentures. But here, the scheme may not be successful without affecting reorganization. The total amount of funds available for an undertaking is broadly divided into owned capital and borrowed capital. (iv) Management should follow a conservative policy in declaring dividend and should take all measures to cut down unnecessary expenses on administration. (ii) Long-term borrowings carrying higher rate of interest may be redeemed out of existing resources.

In both the cases, the real value of the company would be below its book value and the earnings very low. Absence of suitable depreciation policy would make the asset-values superfluous. Lowered earnings bring about fall in share values, which represents over-capitalisation. In both the cases, the real value of the company is below its book value and the earnings are very low.

When analyzing a business that is still operating but has an unusually low amount of capital, certain investment metrics can be misleading. For example, the return on equity percentage will look higher than comparable but more amply capitalized businesses because the value of the equity in the calculation’s denominator is smaller. In turn, the higher dividends and return ratios inflate the share price in the short term, giving shareholders unsustainable appreciation in the share price. In all cases, a company that is undercapitalized and unable to fund its operations and pay its bills faces insolvency in the medium to long term.

If the rate of capitalisation is under-estimated, it will lead to a situation of over-capitalisation. There are many factors which account for the situation of over-capitalisation of a company. Assets might have been acquired at low costs during necessary conditions in the market. «Whenever the aggregate of the par value of stock and bonds outstanding exceeds the true value of fixed assets, the corporation is said be over-capitalised.» (iii) The par value and/or number of equity shares may be reduced.