This may adversely affect its earning capacity and lead to over-capitalisation. If a company borrows large amount of capital at higher rate of interest than the rate of its earnings to meet its emergent needs, the company would be ultimately over-capitalised. Since a major part of its earnings is taken away by the creditors as interest, the rate of dividend would naturally fall, and the market value of shares would decline. Thus, lower market price of shares than the book value would make the company over-capitalised. If a corporation raises more capital than it can employ productively, overcapitalisation may result. In this situation, a significant proportion of capital is idle or inefficiently used.
Over Capitalisation of a Company: Meaning, Causes and Effects
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. If the rate of capitalisation is under-estimated, it will lead to a situation of over-capitalisation. 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. Effects of over-capitalisation are so grave that the management should take immediate measures to remedy the situation of over-capitalisation as soon as the symptoms of the over-capitalisation are observed.
Overpriced assets would require higher capital investments that can lead to the overcapitalization of a company. Overcapitalization in working capital is also an indication of the underutilization of assets by a business. Particularly, if a business does not properly utilize its cash reserves, it would lead to overcapitalization due to increased debt and equity capital funding. Thus, we see that as a result of over-capitalisation, the rate of earnings has dropped from 10% to 8⅓%.
If the depreciation or replacement provision is not adequately made, the productive worth of the assets is diminished which will definitely depress the earnings. Lowered earnings bring about fall in share values, which represents over-capitalisation. 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%.
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By its nature, inflationary conditions are an important factor in over capitalisation of business enterprises, and equally affect both the newly promoted as well as the established companies. During boom period, companies have to pay high prices for purchases of fixed assets, and the amount of capitalisation is kept high. Higher capitalisation is justifiable until inflationary conditions prevail.
In case of overcapitalization, the total equity (owner’s capital + debt) of a company exceeds the actual worth of its assets. In simpler terms, it occurs when a company’s assets are overvalued compared to their actual earning potential. 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.
Excessive Capital Funding
Redemption of preference shares particularly of cumulative preference shares reduces over-capitalisation. Infosys is actively addressing its overcapitalisation by implementing share buyback programs. This strategic move involves repurchasing its own, effectively reducing the number of outstanding shares. (ii) There is a capital loss to the members; as a result of the poor market value of their shares. (ii) Fair rate of return means the prevailing rate of return; which other companies in the industry- doing similar business are paying. A business is said to be overcapitalised if the value of its debt and stock exceeds the value of its whole assets.
Overcapitalization may lead to a decline in earning capacity of the company. Degraded earnings would hint towards the instability of business operations which may consequently lead to a downfall of share prices causing a ripple effect. Over-capitalisation leads to increased losses, poor quality of products, retrenchment or unemployment of workers, decline in wage rates and purchasing power of labour. This tendency gradually affects the entire industry and the society, and may lead to recession of economy. (iv) Loss on speculation, the prices of the shares of an over-capitalised company remain unstable because of speculative dealings in such shares.
Undercapitalization occurs when a company has neither sufficient cash flow nor access to the credit it requires to finance its operations. The company may not be able to issue stock on the public markets because the company does not meet the requirements or because the filing expenses are too high. Long term debentures and bonds when redeemed reduce over-capitalisation. The company may, instead of issuing more shares, utilize its accumulated earnings for reorganization.
Accordingly, its market value is lower than its capitalised value. Thus, their rate of return reduces from 20% to 16% due to overcapitalization. XYZ company is engaged in the construction business in the Middle East and earns a sum of $80,000 with a required rate of return, of 20%. Managing working capital and cashflows plays a crucial role in managing capital investment for any business.
- Inadequate depreciation causes inefficiency in the company which, in turn, results in its reduced earning capacity.
- The entire society may exhibit this propensity, and a recession may result.
- The excess capital, in this case, represents idle funds that do not produce any benefits or profits for the company.
- (ii) If an over-capitalised company is liquidated untimely due to this financial disease; workers lose their employment.
- (iii) An over-capitalised company may not be able to pay interest to the creditors regularly.
Working Capital Issues
As a result, the company’s earnings shrink, which causes its stock’s market value to decrease. Everybody knows that having too much of anything is wrong, and the financial world is no exception. The term “capitalisation” in corporate finance refers to a firm’s total holdings of debt and equity. As a result, it defines the entire amount of capital spent in the business. Undercapitalized companies do not have sufficient cash reserve through retained earnings either. Due to their distressed financial situation, they cannot acquire external capital investment as well.
Effects of Over-capitalisation on Company:
- One common cause for overcapitalization is acquiring assets at inflated prices.
- Underestimating the capitalization rate causes the company to raise more money than it might profitably use.
- Join us as we unravel the complexities of overcapitalisation and its implications for businesses.
- This hampers growth of the company; leading to a gradual but permanent decline in its earning capacity and producing over-capitalisation.
- Providing inadequate depreciation results in over-capitalisation as it leaves insufficient provision for replacement of assets.
(i) Because of reduced profitability, workers might be required to suffer a cut in their wages. An over-capitalised company has an excess of capital; but only in a superficial sense. The excess of Rs. 10, 00,000 as per illustration given above, represents idle funds – not producing any benefits or profits, for the company.
But when the boom conditions subside and recessionary conditions set in, the real value of the company’s assets fall whereas the book value of its assets remain at a, higher level. A corporation will become overcapitalised if causes of over capitalisation it borrows a significant amount of money at an interest rate higher than the pace at which its earnings grow. The dividend rate would logically fall, and the market value of the shares would decrease, as the creditors’ revenues would strip away a significant portion of its revenues as interest. Therefore, if the market price of the shares is below the book value, the firm is over-capitalised. An over-capitalised company will not be able to pay a fair rate of dividend to its shareholders because it is earning a low rate of return (earnings) on its capital.
Preference shares carrying high rate of dividend should be redeemed out of retained earnings in order to raise the share of equity shareholders. 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.
Therefore, we can say that the test of over—capitalisation is the lower rate of return on capital over a long-term. Shareholders suffer doubly the brunt of over-capitalisation. Not only does their dividend income fall but also its receipt becomes uncertain. They also suffer because capital invested by them in these companies depreciates due to fall in market value of their shares.
No consideration is given to the demands of the workers and some of them even lose their jobs because of lay offs and retrenchment and closure of such units. An over-capitalised company has to often resort to reorganisation and reduction of its capital in order to write off the accumulated losses. This results in the reduction of face value of shares and loss to its owners. As, shareholders 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.
