An increased cost of interest would keep working capital management under constant pressure that will result in further borrowings. (i) Because of reduced profitability, workers might be required to suffer a cut in their wages. (iii) The par value and/or number of equity shares may be reduced. (i) The profits of an over-capitalised company would show causes of over capitalisation a declining trend. Such a company may resort to tactics like increase in product price or lowering of product quality.
Remedies of Over Capitalization
These inflated profits lead to payments of dividends out of capital. Sometimes, while floating a new company, the promoters over-estimate the financial requirements, and as a result, they raise more capital than what is actually needed, resulting in over-capitalisation. In terms of earnings, over-capitalisation arises when the earnings of the company are not sufficient to give a normal return on capital employed by it. Simply stated, over-capitalisation means more capital than actually required, and therefore, in a over capitalised concern, the invested funds are not properly used.
Better Financial Forecasting
Eventually, it will look for external capital investment resources. Thus, a revised dividend policy can also work in favor of a business here. In the present day times, the corporate taxes are quite high. These leave little profits in the hands of management for reinvestment purposes, and for paying a fair rate of return on the equity.
- It means a business has funded more capital than it acquired assets that result in overcapitalization.
- (i) The poor functioning of an over-capitalised company implies wastage of nation’s precious economic resources; as the same amount of resource might be profitably employed elsewhere, to produce more.
- Inventories lie in store for pretty long time and substantially large amount of capital is unnecessarily tied up in them.
EXIM Policy: 1997 to 2002 and 2002 to 2007
A company may have large secret reserves due to which its profitability is higher. It is a fine method if the equity shareholders are ready to give their consent to it. The total amount of funds available for an undertaking is broadly divided into owned capital and borrowed capital.
Instead of $1,000,000, Company ABC decides to use $1,200,000 as its capital. The rate of earnings in this case becomes 17%, or $200,000 ÷ $1,200,000 × 100. Due to overcapitalization, the rate of return has dropped from 20% to 17%. Here’s a hypothetical example of how overcapitalization works.
The total amount of equity share capital of the company is Rs. 18 lakhs and total assets amount to Rs. 30 lakhs. Market value of shares is the price at which shares of a company are quoted in stock exchange. A number of factors can lead to a company becoming overcapitalized. A company may become overcapitalized if it buys assets that are priced too high or acquires assets that don’t fit into its operations.
Therefore, we can say that the test of over—capitalisation is the lower rate of return on capital over a long-term. It is often suggested that an over-capitalized concern should reduce the amount of stock outstanding by reducing par value of shares. This is nothing but reorganization of share capital which helps the concern in obscuring the real state of affairs. Supposing a company is capitalized at Rs. 10,00,000 with 5,000 ordinary shares of Rs. 200 per share and the company’s average annual earning is Rs. 50,000. Taxation policy of the Government may also be responsible for company’s over-capitalisation.
Effect of over capitalization is so grave that the management should take immediate measures to rectify the situation of over capitalization as soon as the symptoms of over capitalization are observed. The state of over capitalization affects the company and its owners and also engulfs the society as a whole in the following manner. The temptation to raise product pricing to boost profits is too great for a corporation to deny, and there is a good chance that the product’s overall quality will suffer as a result. Capital restructuring is one option for a company facing overcapitalization problems. A business can plan according to its expansion and growth needs. (ii) Closure of an over-capitalised company hits the society adversely; in terms of loss of production, generation of unemployment, etc.
They cannot remain competitive, and they are edging closer to a point where liquidation is required even though the existence of these worries cannot be substantiated. As a result of falling wages, workers’ purchasing power decreases. The entire society may exhibit this propensity, and a recession may result. Intensive capital investment is a clear indicator of a business with overcapitalization.
