over capitalisation meaning: What is Capitalisation ? Definition, Causes, Remedies, Consequences of Over & Under Capitalisation

Choice of book value, therefore, appears to be relatively more logical. As for market value, there is no doubt that present condition of a firm is reflected in market value of its share. Reduction in face value of shares is one of the solutions to overcapitalization. Over-capitalisation affects not only the company and its owners but also the society as a whole. For a company faced with a situation of over-capitalisation, it is very difficult to obtain further capital for its growth and expansion programmes. It is so because the investors have already lost confidence in the company.

In fact, under-capitalisation is indicative of sound financial position and good management of the company. Essentially, the company cannot raise capital to fund itself, its daily operations, or any expansion projects. Undercapitalization most commonly occurs in companies with high start-up costs, too much debt, and insufficient cash flow.

In this case, shares are neither issued on premium nor at discount. Par value is static in character that remains unaffected by business oscillations. While investing money in existing ventures investors are interested to know whether company in question is over-capitalized or not. Similar question arises in the event of amalgamation, merger or reorganization of companies. A high amount ofpreliminary expensesmay be a reason for overcapitalization as they are shown as assets i.e.fictitious assetsin the balance sheet.

If the rate of capitalisation is under-estimated, it will lead to a situation of over-capitalisation. Incurring high promotional expenses, excessive preliminary expenses etc. may lead to over-capitalisation. There are many factors which account for the situation of over-capitalisation of a company. As a result of this, earning per share tends to go up by the same proportion.

Consequences / Disadvantages of Over – Capitalisation

Debt To Equity RatioThe debt to equity ratio is a representation of the company’s capital structure that determines the proportion of external liabilities to the shareholders’ equity. It helps the investors determine the organization’s leverage position and risk level. Also it does not take into consideration proprietary reserves and surplus, nevertheless ordinary shareholders have control over them. International events also influence market price of shares.

In this case, the company ends up paying more interest and dividends, which is impossible to sustain in the long term. It simply signifies that the company is not using the fund efficiently and has poor capital management. It may not be out of place to mention that a company is said to be over-capitalized only when it has not been able to earn fair income over a long period of time.

As, over capitalisation meaningholders are the real owners of a company, they suffer most on account of over-capitalisation. Reduced earnings of an over-capitalised concern affect its creditworthiness and as a result, it becomes difficult for it to get loans or credit at cheaper rates of interest. Procurement of funds at high rate of interest will adversely affect the company resulting in over-capitalisation. It promoters buy assets of lower values at higher prices, they are led to a situation of over-capitalisation because assets of lower value will be shown at higher value in the Balance sheet. The failure of such over-capitalized concerns tends to precipitate panic. Industrial development languishes, and labourers lose employment.

Within this sector, an individual pharmaceutical company M/s XYZ Inc generates annual profits of $100,000 with a total funding of $1,200,000. If the returns of XYZ Inc are to be compared with its sector average, it should have a capital funding of $1,000,000 to justify its returns (100,000/10%). It thus can be considered to be overcapitalized to the extent of $200,000. Overcapitalization is a financial situation in which the value of equity and debt issued by a company exceeds the value or worth of its assets, specifically its fixed assets. It is essentially a state in which a company is over-funded. There can be several factors that may cause a company to become overcapitalized.

Over-Capitalisation: Meaning, Effects and Remedies

Public feels being overcharged on the one hand, and expects such firms to raise innovations, on the other. In the stock market for such firms often unhealthy things get into currency. A company is said to be over-capitalized when its earnings are not sufficient to justify a fair return on the amount of capital raised through equity and debentures.

• Occurs when a company has issued more in debt and equity than its assets are worth.
• Overcapitalization may lead to a decline in earning capacity of the company.
• The enterprise can make use of these funds for the purposes of replacement of assets and expansion of business activity.
• This results in short term liquidity problems for the business.

Then the book values will be much more than the economic value. To reduce rate of interest on debentures and the rate of dividend on preference shares. Borrowing of large money at a rate of interest fairly higher than- the actual rate of return on its capital employed. Suppose, Cachar Paper Mill, Panchgram earned an annual profit of Rs. 50,000 on its total capital investment of Rs. 5, 00,000.

Fraudulent Capitalization

In such situations, there is a possibility of charging inflated prices rather than real value of assets. Acquisition of unproductive assets or buying them at inflated prices may also result in overcapitalization of a company. Are not accepted in any of the economic principles or the smoothing functioning of the company as it affects the company’s financial stability and revenue leakage. UndercapitalizationUndercapitalization in business means a scenario where a company faces a shortage of funds or capital requirements to continue its day-to-day operations. The company in these moments also faces a lack of ability to procure any new source of funding or capital.

Due to depression, many times it may become difficult to procure the necessary amount of capital. During depression period, long term assets are purchased at a lower rate and the earning rate is more than the value of it. On the above definition, it can be stated that basis of capitalisation is not a economic problem.

High rates of taxation may leave little in the hands of the company to provide for depreciation and replacement and dividends to shareholders. This may adversely affect its earning capacity and lead to over-capitalisation. 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 over- capitalisation. But when boom conditions cease prices of products decline resulting in lower earnings. The original value of assets remains in books while earning capacity dwindles due to depression.

MEANING| ADVANTAGES| DISADVANTAGES OF CONTINUOUS AUDIT

Broadly speaking, capitalisation refers to the act of deciding in advance the quantum of fund requirements of a firm, its patterns and administration of capital in the interest of the firm. Balance SheetA balance sheet is one of the financial statements of a company that presents the shareholders’ equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner’s capital equals the total assets of the company. The directors of the company may over-estimate the earnings of the company and raise capital accordingly. If the company is not in a position to invest these funds profitably, the company will have more capital than is required. Consequently, the rate of earnings per shares will be less.

Our team of rehttps://1investing.in/ers are established professionals with decades of experience in areas of personal finance and hold many advanced degrees and certifications. At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content. When companies are acquired, the company may pay for goodwill more than its net worth. The company may have such an amount of funds that it cannot use them properly. Money may be living idle in banks or in the form of low yield investments.

A concern is said to be over-capitalized if its earnings are not sufficient to justify a fair return on the amount of share capital and debentures that have been issued. It is said to be over capitalized when total of owned and borrowed capital exceeds its fixed and current assets i.e. when it shows accumulated losses on the assets side of the balance sheet. The situation of over-capitalisation may also be corrected by persuading the existing shareholders to agree to accept new shares with reduced par value. Obviously, this would reduce the amount of capitalisation and improve the earning capacity of the company. However, it is very difficult to shareholders in this regard as they take it as a convince the trick to deceive them.

Difference between Over Capitalization and Under Capitalization of Company

The company may divide the denomination of stock into small value to increase the number of shares. The company can try to retire its debt capital to reduce the burden of paying fixed interest. However, this is not an easy task as large amounts of funds are required to pay the debt off; this can be done by issuing new shares. Due to fall in price of stock the shareholders will be the biggest losers.

Being overcapitalized means that a company’s capital management strategies are running inefficiently, placing it in a poor financial position. An overcapitalized company may often be burdened by interest payments or payment of profits as dividends to shareholders. It may not be always correct to recognize excess capital as overcapitalization as most such firms suffer from lack of liquidity, a more reliable indicator would be the earnings capacity of the business. It must be clear that a company is said to be over-capitalised only when it has not been able to earn fair income over a long period of time. In such a situation, the real values of a company’s total assets would be less than their book values.

Due to inadequacy of capital, many times a company has to borrow funds from outside sources at a higher rate of interest which may create additional obligation on the company. Due to a continuous increase in profitability rate, workers may demand an increase in wage rates and other benefits. If the demands are not fulfilled, they can create various problems. It may lead to cut-throat competitions because a high rate of dividend may encourage potential competitors to enter the market.

This hampers growth of the company; leading to a gradual but permanent decline in its earning capacity and producing over-capitalisation. In order to decrease the rate of earnings per share, the directors of the company take the decision regarding splitting up of shares. It does not affect the total capitalisation but it affects on a decrease in par value of stock. However, market value, in fact, is consequence of cumulative effects through internal and external factors.