Process of capital formation is hampered and development activity slackens and the economy is thrown out of gear. Secondly, these companies may, in times of necessity, be compelled to take recourse to costlier borrowing which, in turn adversely affects their earning position. The combined effects of these may land these companies in state of over-capitalisation.
It is, therefore, quite clear that over-capitalisation may be explained in terms of earnings as well as cost of assets. It is also suggested that with a view to improving their earning position over-capitalized concerns should slash down the burden of fixed charges on debt. For that matter, existing bond holders will have to be made to agree to accept new bonds carrying lower interest rate in lieu of their old ones. The bondholders might agree to accept the new bonds provided these are issued to them at premium. We shall now examine efficacy of each of these measures as curative to the problem of over-capitalisation. Not only does their dividend income fall but also its receipt becomes uncertain.
The findings of such investigations should help management determine if management abuse, miscalculation of capital needs, or poor Financial Statements are the primary causes. If so, then corrective measures may include reducing dividends payable, reducing the number of shares by way of causes of over capitalisation share buybacks, or increasing the par value of existing shares. There can be several factors that may cause a company to become overcapitalized.
These firms find themselves overcapitalized after the boom period is over. In view of these factors, market value of shares oscillates violently. Market value of shares of a corporation can at best be worked out by averaging out the market price of shares of the company ruling in the market over different dates.
- Lower earnings bring down the value of shares leading to over-capitalization.
- The earning capacity of the company should be raised by enhancing the efficiency of human and non-human resources belonging to the company.
- 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.
- Companies following too liberal dividend policy continuously for long period of time shall be definitely deprived of the benefits of retained earnings.
Sometimes the services of the promoters are valued at an unduly high price. A business is said to be overcapitalised if the value of its debt and stock exceeds the value of its whole assets. Accordingly, its market value is lower than its capitalised value. A business can take a more calculated approach to avoid overcapitalization problems. Although it depends on the business size and future plans of a company, here are a few key steps to avoid such situations. We can see a few common indicators of an overcapitalized business generally.
Factors Affecting the Working Capital
Also it does not take into consideration proprietary reserves and surplus, nevertheless ordinary shareholders have control over them. How to test over-capitalized situation is difficult but a vital question that needs serious attention. According to some scholars, when par value of shares of company is higher than the market value, the company would be in state of over-capitalisation. It may issue the minimum share capital and may meet the additional financial requirements through borrowings at lower rates of interest. Under-capitalization is a condition where the real value of the company is more than its book value.
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 the 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. Overcapitalization, in other words, refers to the underutilization of funds.
Understanding Overcapitalization
We can illustrate over-capitalisation with the help of an example. With the expected earnings of 15%, the capitalisation of the company should be Rs. 20 lakhs. But if the actual capitalisation of the company is Rs. 30 lakhs, it will be over-capitalised to the extent of Rs. 10 lakhs.
Overcapitalisation can be detrimental to a company, including reduced return on investment, lower profitability, and an inefficient allocation of resources. It can result from factors like overvalued assets, excessive borrowing, or overly optimistic growth expectations. Overcapitalisation is a financial state in which a company’s capitalisation, consisting of equity and debt, exceeds its actual operational needs and the value of its underlying assets. When a corporation raises more funds than necessary, leading to an imbalance between capital investment and productive utilisation. Overcapitalisation is a financial phenomenon that occurs when a company’s capital structure consists of an excessive amount of capital, often more than is required for its operations and growth plans. This surplus capital can negatively affect the corporation’s financials and profits and return on investment.
Causes of overcapitalisation
(ii) The company may not be able to raise fresh capital from the market. The company might incur heavy preliminary expenses such as purchase of goodwill, patents, etc.; printing of prospectus, underwriting commission, brokerage, etc. To cover for one loss, other losses are incurred by the company and in the process overall efficiency of the company declines. Such a company usually does not make adequate provisions for depreciation, repairs and renewals, etc., leading to further decline in its efficiency.
They also suffer because capital invested by them in these companies depreciates due to fall in market value of their shares. Value of their holdings as collateral securities declines simultaneously. Sometimes, over-capitalisation may be the result of shortage of capital.
