Inadequate owned capital, defective financial plan, excessive borrowing, high interest charges, shareholders suffer — dividend falls and falling market value of shares. In conclusion, overcapitalisation can have significant consequences for a company and its stakeholders. It arises when a company raises more capital than it can effectively deploy in its operations, leading to inefficiencies, reduced profitability, and even financial distress.
Over-capitalisation affects not only the company and its owners but also the society as a whole. Over-capitalisation is a state that affects not only the company and its owners but also the society as a whole. Consequently, lion share of firm’s income may be swallowed by the lenders who come to the firm’s rescue in eventuality, leaving little income available for the shareholders.
Mismanagement in working capital can also lead to the overcapitalization of a company. Investors may lose confidence in an overcapitalized company as there may be no assurance of any income due to low earning capacity. Acquisition of unproductive assets or buying them at inflated prices may also result in the overcapitalization of a company.
Many companies prefer to declare a higher rate of dividend instead of retaining a part of the profits and ploughing causes of over capitalisation them back or reinvesting them. Such a practice should be discouraged as it leads to over-capitalisation, because liberal dividends are paid at the cost of inadequate provision for depreciation. To cut the knot of over-capitalisation, over-capitalized concerns are suggested to reduce the amount of bonded indebtedness to prune the amount of capital in accordance with their earning position. Redemption of debt needs additional funds which can be procured either from reinvested earnings, or from sale of additional stock.
Better Financial Forecasting
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%. Thus, over-capitalisation refers to that state of affairs where earnings of the corporation do not justify the amount of capital invested in the business. In other words, an over-capitalized company earns less than what it should have earned at fair rate of return on its total capital. If a company has small share capital it will be forced to raise loans at heavy rate of interest. This would reduce the net earnings available for dividends to shareholders.
Lower earnings bring down the value of shares leading to over-capitalisation. 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. Other reasons include poor corporate management, higher-than-expected startup costs (which often appear as assets on the balance sheet), and a change in the business environment. Although it may seem detrimental to a business, there is one advantage to being overcapitalized.
Suppose the book value of the assets of a company is Rs. 25, 00,000 (represented by a capitalisation of 25, 00,000, consisting of equity capital, preference capital and debentures). However, suppose, the real value of assets as warranted by their earning capacity is only Rs. 15, 00,000. There is, then, over-capitalisation in the company, to the extent of Rs. 10, 00,000. In short, a firm will be seen to be overcapitalised if it cannot obtain a reasonable or prevailing rate of return on its capital. As a result, the market value of its shares has consistently fallen below the book value over time. One common cause for overcapitalization is acquiring assets at inflated prices.
- Acquisition of unproductive assets or buying them at inflated prices may also result in the overcapitalization of a company.
- Consequently, the company’s earnings decline which lead to fall in market value of its shares.
- Such a company may resort to tactics like increase in product price or lowering of product quality.
Understanding Overcapitalization
Such a company may resort to tactics like increase in product price or lowering of product quality. Because of this, the shares of the company may not be easily marketable. (iii) There may be no certainty of income to the shareholders in the future. (v) Because of low earnings, reputation of the company would be lowered. (ii) The company may not be able to raise fresh capital from the market.
A company is over-capitalized when its earnings are insufficient to justify a fair return on the amount of capital raised through equity and debentures. 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. This situation will normally arise when a company raises more capital than what is justified by its actual earnings.
Increased Capital Investment
Here’s a hypothetical example of how overcapitalization works. Assume that construction firm Company ABC earns $200,000 and has a required rate of return of 20%. The fairly capitalized capital is $1,000,000, or $200,000 ÷ 20%.
Effects of Over-Capitalisation:
- This strategic move involves repurchasing its own, effectively reducing the number of outstanding shares.
- If a company does make adequate provision for depreciation and replacement of assets, it will be able to distribute higher dividends to its shareholders for years.
- It means excessive dividend payments can also lead to the overcapitalization of a company in the long run.
- Mismanagement in working capital can also lead to the overcapitalization of a company.
- An over-capitalised company has to often resort to reorganisation and reduction of its capital in order to write off the accumulated losses.
- Inflationary economy prevailing at the time company promotion.
Insufficient provision for depreciation consumes unnecessary profits and reduces the overall earning capacity of the company. The company may follow a liberal dividend policy and may not retain sufficient funds for self-financing. In order to regain the confidence of its investors, over-capitalised companies generally resort to manipulation of accounts and over-statement of their profits.
The only effective remedy to cure over-capitalisation lies in implementing a scheme of a capital reduction. Poor planning of initial equity requirements may result in the overestimation of funds. (iv) Management should follow a conservative policy in declaring dividend and should take all measures to cut down unnecessary expenses on administration. (iv) The company may not be able to provide better working conditions and adequate wages to the workers. (v) In case of reorganisation, the face value of the equity share might be brought down. (ii) Market value of shares will go down because of lower profitability.
An over-capitalisation arises when a company’s dividend rate becomes low because of issue of shares beyond optimum level. When a company follows a liberal dividend policy; it does not have many earnings left for reinvestment purposes. This hampers growth of the company; leading to a gradual but permanent decline in its earning capacity and producing over-capitalisation. Rigorous taxation policy of the Government may also result in over-capitalisation.
(iv) Management may cut down expenditure on maintenance and replacement of assets. Proper amount of depreciation of assets may not be provided for. An over-capitalised concern either misutilises or under utilises its resources.
By applying this rate the company’s capitalisation was worked out at Rs. 1, 25,000. Subsequently, it was found that industry average rate of return was 10 percent and hence company’s fair amount of capitalisation would be Rs. 1,00,000 . Obviously, there is over-capitalisation in the company to the extent of Rs. 25,000. To ascertain whether a company is earning reasonable rate of return or not, a comparison of the company’s rate of earnings should be made with earning rate of the like concerns. If the company’s rate of return is less than the average rate of return, it is indicative of the fact that the company is not able to earn fair rate of return on its capital. The phrase ‘over-capitalisation’ has been misunderstood with abundance of capital.
( Reduction of Fixed Charges on Debt:
She started her financial journey by creating simple budgeting systems for herself and gradually ventured into stock market investing. Over time, Shweta’s passion for empowering others to take charge of their finances led her to share insights on everything from saving strategies to portfolio diversification. Through relatable anecdotes and step-by-step guides, she aims to demystify the complexities of finance, inspiring confidence and clarity in her audience. (iii) A reduction in the paid-up value of shares-equity or preference or both. For example a share of the paid-up value of Rs.10 might be reduced to a share with a paid-up value of Rs. 5 or Rs. 3.