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In other words, under the situation of over-capitalization the par value of shares and debentures of the company is more than the true value of its fixed assets. The most important area of financial planning is to determine the right proportion of debt and equity. The objective of a firm is to create value which can be performed through proper mobilization and use of funds. So the right amount of capitalization is the basic objective of a finance manager. Fair capitalization is that situation where the business has employed the correct amount of capital and its earnings are same as the average rate of earnings. 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.

Remedies of Over Capitalization

Even they will get a lower amount of dividend due to over-capitalization. The term capitalisation, or the valuation of the capital, includes the capital stock and debt. According to another view it is a word ordinarily used to refer to the sum of the outstanding stocks and funded obligations which may represent wholly fictitious values. Under capitalization is the state of affairs of a business, notably in terms of equity capitalization, where there is an excess surplus of assets over the legal requirement of assets. A situation of over-trading by the company may arise as a result of under-capitalisation, where the company does excessive business than what its finances can allow.

Underutilization of Funds

The company operates for six years during which it has earned the av­erage profits of Rs. 16,000. If the earnings are capitalised at the rate of 5%, the capitalised value of earnings will be Rs. 3,20,000. It means that the company will be having watered capital but it will not be overcapitalised. Such net capital includes profits or gains earned from the use of capital and not distributed to the shareholders and excludes losses incurred in the business from the use of such capital.

Overcapitalization Vs Undercapitalization

It means excessive dividend payments can also lead to the overcapitalization of a company in the long run. Many businesses acquire excessive equity and debt capital fundings than necessary. It may be due to overestimation of capital project costs or overambitious planning.

Difference between Over-Capitalization and Under Capitalization

High rates of taxation may leave little in the hands of the management to provide for depreciation, replacements and dividends. This will adversely affect earnings capacity and thus leads to over-capitalisation. 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.

px” alt=”over capitalisation and under capitalisation”/>over capitalisation and under capitalisation firm is higher than its expected earnings. Equity component of an under­capitalized firm is less than debt in the capital structure. In an under-capitalized firm a part of fixed assets is financed through short-term funds. From the earnings point of view the earning of an over-capitalized firm must be lower than its expected earnings.

• The amount of capitalisation is based on a figure which will not change with changes in the earning capacity of the business.
• But if the actual capitalisation of the company is Rs. 30 lakhs, it will be over-capitalised to the extent of Rs. 10 lakhs.
• Sometimes, the terms watered capital and over-capitalisation are confused for each other, but it is not true.
• As such, the possibility of the existence of the watered stock or watered capital can be traced with the intention of the promoters who sell the shares.

(v) Because of low earnings, reputation of the company would be lowered. The company might incur heavy preliminary expenses such as purchase of goodwill, patents, etc.; printing of prospectus, underwriting commission, brokerage, etc. Spotify’s operating expenses plunged 16% year over year in the second quarter, reflecting recent layoffs. It announced a 17% staff reduction late last year, a necessary move to bring costs down. Debentures, public deposits and loans taken at higher rates of interest should be prepaid out of accumulated profits or out of fresh borrowings at lower rates of interest, if there are no accumulated profits. An over-capitalised company goes into liquidation unless drastic steps are taken to re-organise the whole capital structure, and re-organisation would itself lead to a lot of problems.

For example, a company’s earning was estimated at Rs. 10,000 and the industry average rate of return was fixed at 8 percent. It is an imbalanced condition between par value of capital and true value of fixed assets of a concern. Generally this situation is indicated by earnings of the company and not by the excess of capital. In other words, lower rate of earnings compared to the expected return is explained as over-capitalization.

(2) Sometimes, the company pays a higher price to the vendors of the assets transferred i.e. the price which is more than the worth of the assets. (a) Under capitalisation leads to unhealthy speculation on the stock exchanges, which affects investment climate adversely. In simple terms, over capitalisation means existence of excess capital as compared to the level of activity and requirements. (ii) The amount of capitalisation arrived at on the basis of earnings can be used as a standard for comparison. Lincoln – “Capitalisation is a word ordinarily used to refer to the sum of the outstanding stocks and funded obligation which may represent wholly fictitious values”. However, it should be noted that in actual practice both reserves and surpluses are frequently used by the companies to meet their long-term requirements.

Some of the key factors include poor accounting records, miscalculation of capital needs, abuse by management of shareholders’ funds, and poor financial analysis. Under-capitalization is https://www.1investing.in/ a condition where the real value of the company is more than its book value. The assets bring profits but it would appear to be much larger than warranted by book figures of the capital.

(c) A part of the capital is either idle or invested in assets which are not fully utilised. Timothy Green has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Spotify Technology and Uber Technologies. In 2019, the last full year before the pandemic rocked Uber’s business, the company reported a staggering $8.6 billion operating loss on more than $14 billion in revenue.

(ii) The company may not be able to raise fresh capital from the market. (1) Acquiring of fictitious assets like goodwill at high prices. The company may obtain high degree of efficiency by utilizing its assets opti­mally and exploring all the opportunities. It is not the face value of a share at which it is normally issued, i.e., at premium nor at discount, it is static and not affected by business oscillations. The ordinary meaning of capitalisation in the computation appraisal or estimation of present value.

This leads the company to a situation of under-capitalisation. 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. It must be clear that a company is said to be over-capitalised only when it has not been able to earn fair income over a long period of time.

Undercapitalization refers to a situation where a business does not have sufficient capital investment as compared to its needs. One of the major reasons a company falls into overcapitalization issues is the inaccuracy of its financial forecasting. It estimates significant growth and overestimates its capital requirements. Better financial forecasting can avoid such problems in the future. One common cause for overcapitalization is acquiring assets at inflated prices. Overpriced assets would require higher capital investments that can lead to the overcapitalization of a company.

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. In other words, a company is said to be over-capitalised when it is not able to pay interest on debentures and loans and ensure a fair return to the shareholders. Liberal dividend policy may also contribute to over-capitalization of a company. Companies following too liberal dividend policy continuously for long period of time shall be definitely deprived of the benefits of retained earnings. Thus, in the first instance such companies fail to build up sufficient funds to replace old and worn-out assets and consequently, their operating efficiency suffers.