The assets bring profits but it would appear to be much larger than warranted by book figures of the capital. In such cases, the dividend will naturally be high and the market value of shares will be much higher. If the establishment of a new company or the expansion of an existing concern takes place during the boom period, it may be a victim of overcapitalization. Assets may be acquired at inflated prices or at a time when the prices were at their peak. In both cases, the real value of the company is below its book value and the earnings are very low. An enterprise may have acquired assets at a time when it was very costly to do so.
Remedies for Over Capitalization
If a company is to be floated during an inflationary period, or any development activity is carried out in such a period, it will be a victim of over-capitalisation because it has to spend huge amounts. (3) Showing assets at increased value due to lack of proper depreciation policy. (1) Acquiring of fictitious assets like goodwill at high prices.
New debentures may be issued at lower rate of interest with some premium, of course. The situation created by over-capitalisation may be alleviated though not eliminated. Redemption of preference shares particularly of cumulative preference shares reduces over-capitalisation. Managing working capital and cashflows plays a crucial role in managing capital investment for any business. Thus, if a business can keep its cashflows and working capital smooth, it can avoid the problems of capitalization.
Corrective Measures to Limit the Negative Effects of Overcapitalization
This situation will lead to the overcapitalization of the company. Undercapitalized companies do not have sufficient cash reserve through retained earnings either. Due to their distressed financial situation, they cannot acquire external capital investment as well. Sometimes a business following a large-dividend policy may end up with low cash reserves.
Certain companies do not believe in making adequate provisions for various types of reserves and distribute the entire profit in the form of dividends. Such a policy reduces the real profit of the company and the book value of the shares lags much behind its real value. Declining rates of return and dividend rates are strongly suggestive of overcapitalization. If overcapitalization is an issue, the supply of long-term funds exceeds the required amount of funds, or the economic activities of the enterprise decelerate. An overcapitalized company has a market value less than its total capitalized value or current value, and may end up paying more in interest and dividend payments than it can sustain in the long term. Overcapitalization is when a company’s capital is worth more than its total assets.
What are the possible causes of overcapitalization?
Essentially, it’s a scenario where the company is burdened with an excessive amount of capital, resulting in a suboptimal utilization of resources and potentially leading to financial instability. Floatation of a firm during a boom period leads to assets being acquired t inflated prices. But it is not able to increase its earnings accordingly and hence becomes over-capitalized.
Inadequate Provision of Depreciation
- For similar reasons, banks and other financial organisations are reluctant to provide loans.
- As a matter of fact, such payments are made out of capital and to cover capital deficiency they take recourse to debt which would further aggravate the crisis.
- These inflated profits lead to payments of dividends out of capital.
- In short, undercapitalization is a situation where the profitability of a firm is much higher as compared to the capital employed.
- For instance, a sudden drop in the value of net assets may show an overcapitalized business.
- Consequently, operating efficiency of companies suffers drastically and state of over-capitalisation develops in companies.
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%. It loses investors’ confidence owing to irregularity in dividend declaration caused by reduced earning capacity. Consequently, it has to encounter enormous problems in raising capital from the capital market to cover its developmental and expansion requirements. Commercial banks too feel causes of over capitalisation shy of lending short-term advances to such a company to meet its working capital requirements. 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.
