However, benefits like this aren’t necessarily beneficial for a business in the long run. 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. Many businesses acquire excessive equity and debt capital fundings than necessary.
Possible Solutions to Overcapitalization
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. If a business does not retain sufficient profits for internal growth, it will need to borrow more money.
It means it is the opposite situation of overcapitalization. The rate of return falls because ABC company produced the same profit using more capital resources than it required. If ABC uses more capital than causes of over capitalisation its fair capital requirement of $ 2 million, it will be considered an overcapitalized firm. Suppose it has invested $ 2.5 million in total capital investment. A business can end up with excessive capital funding due to several reasons.
- Up until inflationary conditions take hold, higher capitalization is acceptable.
- When the promoters or managers incorrectly overestimate the company’s earnings, this will lead to overcapitalisation because it won’t produce a fair rate of return that is common in the market.
- Such a company usually does not make adequate provisions for depreciation, repairs and renewals, etc., leading to further decline in its efficiency.
- Sometimes a company prefers to follow a liberal dividend policy instead of ploughing hack its profit.
- In simpler terms, it occurs when a company’s assets are overvalued compared to their actual earning potential.
Inadequate depreciation:
Value of their holdings as collateral securities declines simultaneously. With slackening of boom conditions followed by declining trends in earning level, companies gradually turn into over-capitalized ones. Even the existing ventures expand the scale of their business to exploit the earning opportunities which will necessitate the raising of further capital. These firms find themselves overcapitalized after the boom period is over.
Due to higher tax burden, very little amount is left with the company for dividend distribution among the shareholders at a prevailing rate, which is a symptom of overcapitalisation. Moreover, the company may face shortage of funds for both working capital as well as for financing the renewals and replacements of wornout assets. Consequently, the working efficiency of the company will be decreased, and the prices of its shares will fall. By their very nature, inflationary conditions significantly contribute to the overcapitalisation of business enterprises and have an equal impact on newly developed and established businesses. Companies must pay high prices for fixed assets during a boom and maintain elevated capitalisation levels. Up until inflationary conditions take hold, higher capitalization is acceptable.
Acquiring assets at inflated prices:
Consequently, the share of the declining trend which would prices of the company will show a indicate over-capitalisation. Overcapitalisation may also emerge from the government’s strict taxation policies. A sign of overcapitalisation is that the company has very little money left after paying higher taxes to distribute dividends to shareholders at the current rate. Additionally, the business can run out of money for working capital and funding to substitute and restore worn-out assets. As a result, the company’s productivity will decline, and the value of its shares will diminish. It is less the case with those contemporary financial instruments that are valued not for their returns, but for their potential earnings upon resale.
- As a result, its market value is less than its capitalized worth.
- 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.
- It may be noted that over-capitalisation is not exactly the same as excess of capital.
- This leads to the inability of the company to pay normal rate of dividend and interest on shares and debentures respectively, and the .consequent fall in the market value of its shares.
- Owing to fall in purchasing power of the labour class their demand tends to decline.
Over and under capitalisation are both harmful for a company’s financial health. Read further to know how.
(ii) Long-term borrowings carrying higher rate of interest may be redeemed out of existing resources. (c) A part of the capital is either idle or invested in assets which are not fully utilised.
Defective financial planning may lead to excessive issue of shares or debentures. The issue would be superfluous and a constant burden on the earnings of the company. Market capitalization refers to the total dollar value of a company’s outstanding shares. You can easily calculate this figure by multiplying the price of one share by the total number of shares outstanding.
(i) The shares of the company may not be easily marketable because of reduced earnings per share. Likewise, an over-capitalised company must cut its dead weight before it becomes deep rooted and almost impossible to get rid of. The evil effects of over-capitalisation are so grave that the management must take remedial measures to rectify the situation as soon as the first symptoms of over-capitalisation are observed by the firm. An over-capitalised company has been rightly compared with a very fat person who is likely to suffer from various diseases unless he takes steps to immediately reduce his weight. If a company’s products register a constant decline, it will bring down the profitability of the concern and as a result, returns on capital employed will be reduced which represents over-capitalisation. High rates of taxation may leave little in the hands of the management to provide for depreciation, replacements and dividends.
This malpractice further adds to the losses of the shareholders. For a company faced with a situation of over-capitalisation, it is very difficult to obtain further capital for its growth and expansion programmes. It is so because the investors have already lost confidence in the company. It may be noted that over-capitalisation is not exactly the same as excess of capital. Abundance of capital may be one of the reasons of over-capitalisation but it is not the only reason.
Also it does not take into consideration proprietary reserves and surplus, nevertheless ordinary shareholders have control over them. Assets may be acquired at inflated prices or at a time when the prices were at their peak. In both the cases, the real value of the company is below its book value and the earnings are very low.
Better Financial Forecasting
Capitalization is a term used in corporate finance to describe the total amount of debt and equity held by a company. As such, it defines the total amount of money that is invested in the company itself. Shweta Desai is a personal finance enthusiast dedicated to helping readers make sense of money matters.
(iii) An over-capitalised company may not be able to pay interest to the creditors regularly. This means that financial resources of the public are not being utilised properly. (i) The profits of an over-capitalised company would show a declining trend.
Providing inadequate depreciation results in over-capitalisation as it leaves insufficient provision for replacement of assets. It promoters buy assets of lower values at higher prices, they are led to a situation of over-capitalisation because assets of lower value will be shown at higher value in the Balance sheet. As a result of this, earning per share tends to go up by the same proportion. This, in turn, may help the company to improve its credit position in the market and its share values consequently may soar.
