If remedies are not undertaken to cure the financial health of an over-capitalised company; it will meet with an untimely death. (iii) There is usually, unhealthy speculation, in the shares of an over-capitalised company; which, in turn, brings a bad name to the company. (iv) Management should follow a conservative policy in declaring dividend and should take all measures to cut causes of over capitalisation down unnecessary expenses on administration.
Pros and Cons of Overcapitalization
(iii) There may be no certainty of income to the shareholders in the future. (ii) Market value of shares will go down because of lower profitability. (v) Because of low earnings, reputation of the company would be lowered.
- This problem typically occurs when a business raises more money than its actual earnings can support.
- This is nothing but reorganization of share capital which helps the concern in obscuring the real state of affairs.
- These businesses do not retain sufficient cash and issue large dividends instead.
- Overcapitalization occurs when funds of a long-term nature (e.g., share capital, debentures, and loans) exceed the amount of optimal capitalization.
Real value of shares is found out by dividing the capitalized value of the company’s assets by outstanding number of shares. Overcapitalization, in simple terms, refers to a situation where a company’s capital structure exceeds its actual requirements. It means that the company has raised more capital than it needs to efficiently operate its business operations. This excess capital can be in the form of debt, equity, or a combination of both. This problem typically occurs when a business raises more money than its actual earnings can support. It should be noted that overcapitalisation does not always imply an excess of capital.
If dividends are distributed liberally out of profits, reserves that enhance the earning capacity of the firm are not created. The firm borrows from external sources and raises capital through the issue of shares. In such a situation, the firm finds itself over-capitalized if the high cost of capital is not justified by earnings. It is the capitalization under which the actual profits of the company are not sufficient to pay interest on debentures and borrowings and a fair rate of dividend to shareholders over a period of time.
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. (i) The earning capacity of the company should be increased by raising the efficiency of human and non-human resources of the company.
Heavy borrowing, excessive spending on non-essential assets, and unrealistic assessment of market demand are common causes of overcapitalization. Overcapitalization is when a firm has raised capital over a particular limit, which is inherently unhealthy for the company. As a result, its market value is less than its capitalized worth. In this case, the company ends up paying more interest and dividends, which is impossible to sustain in the long term. It simply signifies that the company is not using the fund efficiently and has poor capital management. A firm should raise long-term funds in a way that it is able to pay interest on borrowed funds and also a fir dividend on equity capital.
Inadequate Provision for Depreciation
Many businesses acquire excessive equity and debt capital fundings than necessary. It may be due to overestimation of capital project costs or overambitious planning. Either way, excessive capital funding is the main reason behind the overcapitalization of a business.
Earning Theory of Capitalization
Due to negative taxation policy firms tax liability increases and is left with small residual income for dividend distribution and retention purposes. Further, such policy also restricts the benefits to tax deduct-ability on account of depreciation provision. Consequently, operating efficiency of companies suffers drastically and state of over-capitalisation develops in companies. 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.
Subsequently, it was found that company actually earned Rs. 8,000. Evidently in such a case company’s capitalisation should have been fixed at Rs. 66,000. Thus, the company will be said to be over-capitalized by Rs. 16,667. In the same way, an overcapitalized company suffers from various adverse effects. It will face dissolution unless corrective measures are adopted. The economic consequences of overcapitalization may be fatal for a company, its shareholders, and society as a whole.
Thus, a company is said to be over capitalized when it earns less than what it should have earned as fair rate of return on its total capital. In the first instance, par value-face value of shares is static in character, which remains unaffected by business oscillation. Secondly, market value of shares of a company is highly volatile. It is a state of affair in which dividend rate is too low to sell shares at their par value. Similarly, the capital gearing ratio will be low and the current ratio will be high. In view of this, market value of shares of a company can at best be worked out by averaging out the market price of shares of the company ruling in the market over different dates.
Sometimes, promoters are tempted by a favourable market sentiment; and resort to an issue of excessive finances, which cannot be profitably employed by the company. The result is over capitalisation; as a large part of excessive finance is non-earning. Now, in the company, earnings are done only with Rs. 15, 00,000; whereas the earnings of the company have to be distributed over a capitalisation of Rs. 25, 00,000.