This means that the net current assets are way to higher than the available needs of the company which puts a restraint to deploy those funds into newer investment opportunities. A company facing overtrading can face a lack of funds due to capital rationing which is the restriction on available funds to an entity. [Here the fixed assets of the company of Rs. 16,00,000 exceed the fixed liabilities in the form of shares and debentures amounting to Rs. 15,00,000 (10,00,000+5,00,000).
Real value of shares is found out by dividing the capitalized value of the company’s assets by outstanding number of shares. By multiplying the average earnings of the company by capitalisation rate company’s capitalized value of assets can be found out which when divided by the number of shares gives real value per share. The face value or the number of equity shares may be reduced in order to rectify over-capitalisation. Sometimes, shareholders may oppose to this proposal but actually their proportionate interest in the equity is not reduced. The amount available due to reorganisation of share capital is utilised for writing off the fictitious assets and other over-valued assets.
https://1investing.in/ activity here represents the routine operations of the business. Capitalization means the amount of capital invested in a business. The capital of the company may comprise various types of securities such as common and preferred stock, debentures, bonds and long term loans which are summed up in the capital account on a balance sheet.
Over-capitalisation leads to lose the confidence of the society, because it is also unable to compete with other business enterprises. Indirectly, it will affect the interest of creditors and workers. Over-capitalisation leads to a decrease in income of the company which ultimately affects a reduction in wages. Over-capitalisation leads to an increase in speculation transactions which adversely affects on the interest of real investors. Over capitalisation leads to the vicious circle of the organisation.
Difference between overcapitalization and undercapitalization:
Alongside this, in anticipation of high earnings during boom period there is strong tendency to fix the capitalisation at high figure. Over-capitalisation may be caused in a company if it raises excessive capital than what it can utilise effectively. In this case, a large amount of capital remains either idle or ineffectively utilised. Consequently, the company’s earnings decline which lead to fall in market value of its shares. Company may be over capitalised if it has paid high promotional expenses in the form of payments to promoters for their services, and excessive price for goodwill, trade marks, patents, copyright, etc. The promoters or the directors of the company may over-estimate the earnings of the company and raise capital accordingly.
This results in short term liquidity problems for the business. Overtrading is an accounting term used to describe a situation where a business entity engages in business activities more than it can actively support from its available funds. This shortage of available funds occurs due to increased capital rationing which results in undercapitalization.
No wonder, the enterprises go into liquidation in course of time. Closer or liquidation of enterprises causes losses to society in terms of production, employment, wastage of resources, etc. In over-capitalisation, the market value of the enterprise’s stock falls and it finds difficult to raise capital.
Corrective Measures to Limit the Negative Effects of Overcapitalization
An over capitalized company is like a bulky person who is not able to carry his weight properly. Such a person is prone to many diseases and is definitely not likely to be requisite active life. Unless the condition of overcapitalization is rectified, the company may suffer from many difficulties.
If its earnings are more than the capital invested, it may be treated as under-capitalisation. Because of the reduction in rate of dividend, it also affects the falling prices of the shares. According to the theory of capitalisation, the capitalisation is the amount of earnings capitalised at a representative rate of return. As such, if capitalisation rate is wrong, the amount of capitalisation will be wrong in such a way that lower the rate of capitalisation, higher will be the amount of capitalisation.
Stages of Capitalisation
Inadequate provision causes inefficiency which results in its reduced earning capacity. Over-capitalisation results in reduced earnings for the company. Market value of shares is the price at which shares of a company are quoted in stock exchange. 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. Thus, we see that as a result of over-capitalisation, the rate of earnings has dropped from 10% to 8⅓%.
- If its earnings are more than the capital invested, it may be treated as under-capitalisation.
- The fairly capitalized capital is $1,000,000 or $200,000 ÷ 20%.
- Under-capitalised organisations cannot successfully continue for long as the is always possibility for liquidation.
- However, it is very difficult to shareholders in this regard as they take it as a convince the trick to deceive them.
- Policies purchased when premiums are low can reduce an insurance company’s profitability.
However, when the amount of capitalization is the same as warranted by the amount of earnings, it is a case of ‘Fair Capitalisation’. The amount of Capitalisation is computed by both cost theory and capitalized value of earning theory. However capitalized value of earning theory is considered to be more scientific and modern. One can highlight upon the justification of the amount of capitalization by considering the earning of the concern. S. Dewing, “capitalization is the sum total of the par value of all shares”. Preferred stock refers to a class of ownership that has a higher claim on assets and earnings than common stock has.
Over-Capitalization: Meaning, Causes and Effect of Over-Capitalization
But the raising of necessary funds for redeeming the high dividend preference shares may further aggravate the situation. If, with the consent of the equity shareholders, par value of shares is reduced, it then becomes very much effective as a remedial measure of overcapitalization. The principal remedies for over-capitalization mostly involve reorganization of the company. Over-capitalisation leads to reduction in rate of dividend on equity shares because the profits are distributed over a large number of shares. Because of inadequate provision for depreciation, replacement or obsolescence of assets may lead to over-capitalisation.
Therefore, we can say that the test of over—capitalisation is the lower rate of return on capital over a long-term. Over-capitalisation may prove to be a menace to society as a whole. Over-capitalized concerns, in their endeavour to maintain their credit, take every possible measure to prevent declining tendency of income. They try to increase the prices and deteriorate the quality of products.
If capitalized optimally, a company will earn a good return on its investment. By contrast, if is it overcapitalized, the company will have a rate of return that is lower than the rate of return in competing firms. Thus, an enterprise is said to be over-capitalised when its earnings are not large enough to yield a fair return on its capital employed, i.e., on the amounts of shares and bonds.
Under capitalisation may take place due to – under estimation of initial earnings, under estimation of funds, conservative dividend policy, windfall gains etc. Under-capitalisation has some evil consequences like creation of power competition, labour unrest, consumer dissatisfaction, possibility of manipulating share value etc.. Overcapitalization is a situation where market value of a company is less than the long term capitalization of that company. Due to these surged capitals the company is likely to pay more interests and dividend payments than it actually should be paying. Overtrading is a situation where the management of a company increases its business activities without injecting further capital into the business.
Company – It has a big impact on the company because of low profits the companies reputation is harmed…. The poor functioning of an over-capitalised company implies wastage of nation’s precious economic resources; as the same amount of resource might be profitably employed elsewhere, to produce more. If possible, preferred stock should be redeemed in a order to reduce the liability of higher dividend. For coming out of over-capltalisation stage, it is essential to reduce the interest rates on debentures, bonds, etc.
But in fact, there is a reserve fund amounting to over capitalisation meaning. 3,00,000. Undercapitalization can occur when a company is not performing at a level that generates sufficient cash flows or is unable to raise sufficient capital through long term debt or equity route. For overcapitalized companies, total profit may increase but the rate of earnings will decline. If, with the agreement with and consent of the equity shareholders, number of equity shares can be reduced, over-capitalisation can also come down.
In fact, it is an index of proper and effective utilisation of capital employed in the concern. Just like overcapitalization, being undercapitalized is not where any company wants to be. Overcapitalization occurs when a company has more debt than its assets are worth. O needs to restructure capital to reduces excessive interest expense and boost equity. The amount of capital invested in business is less than the real value of assets. The amount of capital invested in business exceeds the real value of assets.
If the expectation for return is 10%, this mill will be called properly capitalised. “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.” 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.