Overcapitalization Causes, Adverse Effects, Corrective Measure

Accountants can structure the financials in order to minimize profit, and thus taxes. As a business grows, this approach becomes counterproductive (Van Horn 2006). Frequently, a growing business will apply for a bank loan only to find their entire accounting system under review.

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.

Under-Estimation of Requirements

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. Thus, we see that as a result of over-capitalisation, the rate of earnings has dropped from 10% to 8⅓%. Therefore, we can say that the test of over—capitalisation is the lower rate of return on capital over a long-term. Simply stated, over-capitalisation means more capital than actually required, and therefore, in a over capitalised concern, the invested funds are not properly used. It is, therefore, quite clear that over-capitalisation may be explained in terms of earnings as well as cost of assets. Two key ways to avoid undercapitalization involve creating comprehensive, accurate business plans and monitoring actual results against a budget.

• (3) Showing assets at increased value due to lack of proper depreciation policy.
• (iv) Loss on speculation, the prices of the shares of an over-capitalised company remain unstable because of speculative dealings in such shares.
• Assets might have been acquired at inflated prices or at a time when the prices were at their peak.
• Even profitable, liquid companies may experience undercapitalization.

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.

What is overcapitalization?

It is important to note, nevertheless, that different pronouns are not capitalized. ‘He’ and ‘she’ additionally take the place of an individual’s title, however these words usually are not capitalized unless they fall underneath one of many other rules. Beyond proper nouns, the second rule for capitalization involves titles. Most companies have an asset threshold, in which assets valued over a certain amount are routinely treated as a capitalized asset. Capitalization is a term which has different meanings in both financial and accounting context.

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.

Main Sources of Finance

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.

Such a company usually does not make adequate provisions for depreciation, repairs and renewals, etc., leading to further decline in its efficiency. If a company is to be floated during an inflationary period, or any development activity is carried out in such a period, it will be a victim of over-capitalisation because it has to spend huge amounts. (3) Showing assets at increased value due to lack of proper depreciation policy. Under-capitalization and inadequacy of capital are regarded as inter-changeable terms but there is a difference between these two terms.

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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.

• Secondly, market value of shares of a company is highly volatile.
• Market capitalization refers to the total dollar value of a company’s outstanding shares.
• The evil effects of over-capitalisation are so grave that the management must take remedial measures to rectify the situation as soon as the first symptoms of over-capitalisation are observed by the firm.
• But to take recourse to such practices becomes difficult under the perfect competition and the result is the liquidation of such concerns.

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 causes of over capitalisation 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.

Causes of Overcapitalization

According to Bonneville, Dewey and Kelly, when a business is unable to earn a fair rate of return on its outstanding securities, it is over capitalized. Thus over capitalization refers to that state of affairs where earning of the corporation do not justify the amount of capital invested in the business. The main symptom of over capitalization in a company is the amount of earning which it is making on its total capital.

Higher taxation rates may consume a large portion of earnings and, in this way, deprive shareholders of a dividend at a fair rate. This situation will lead to the overcapitalization of the company. 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.

Inadequate Depreciation

(iv) The company may not be able to provide better working conditions and adequate wages to the workers. (ii) Market value of shares will go down because of lower profitability. (v) Because of low earnings, reputation of the company would be lowered. Companies may also find themselves at risk of becoming overcapitalized when they either mismanage or underutilize the capital they have at their disposal. A financial professional will offer guidance based on the information provided and offer a no-obligation call to better understand your situation. Ask a question about your financial situation providing as much detail as possible.

Assets may be acquired at inflated prices or at a time when the prices were at their peak. In both cases, the real value of the company is below its book value and the earnings are very low. Depreciation may be charged at a lower rate than warranted by the life and use of the assets, and the company may not make sufficient provisions for replacement of assets. Assets might have been acquired at inflated prices or at a time when the prices were at their peak.

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.

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.