Over-Capitalization: Meaning, Causes and Effect of Over-Capitalization!

Meaning of Over-capitalization:

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.

ADVERTISEMENTS:

We can illustrate over-capitalisation with the help of an example. Suppose a company earns a
profit of Rs. 3 lakhs. With the expected earnings of 15%, the capitalisation of the company
should be Rs. 20 lakhs. But if the actual capitalisation of the company is Rs. 30 lakhs, it will be
over-capitalised to the extent of Rs. 10 lakhs. The actual rate of return in this case will go down
to 10%. Since the rate of interest on debentures is fixed, the equity shareholders will get lower
dividend in the long-run.

There are three indicators of over-capitalisation, namely:

(a) The amount of capital invested in the company’s business is much more than the real value of
its assets.

(b) Earnings do not represent a fair return on capital employed.

ADVERTISEMENTS:

(c) A part of the capital is either idle or invested in assets which are not fully utilised.

Causes of Over-Capitalisation:

Over-capitalisation may be the result of the following factors:

(i) Acquisition of Assets at Higher Prices:

Assets might have been 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 would be below its book value and the
earnings very low.
(ii) Higher Promotional Expenses:

The company might incur heavy preliminary expenses such as purchase of goodwill, patents,
etc.; printing of prospectus, underwriting commission, brokerage, etc. These expenses are not
productive but are shown as assets.

(iii) Underutilisation:

The directors of the company may over-estimate the earnings of the company and raise capital
accordingly. If the company is not in a position to invest these funds profitably, the company will
have more capital than is required. Consequently, the rate of earnings per shares will be less.

(iv) Insufficient Provision for Depreciation:

ADVERTISEMENTS:

Depreciation may be charged at a lower rate than warranted by the life and use of the assets,
and the company may not make sufficient provisions for replacement of assets. This will reduce
the earning capacity of the company.

(v) Liberal Dividend Policy:

The company may follow a liberal dividend policy and may not retain sufficient funds for self-
financing. This may lead to over-capitalisation in the long-run.

(vi) Inefficient Management:

Inefficient management and extravagant organisation may also lead to over-capitalisation of the
company. The earnings of the company will be low.

Effects of Over-capitalisation on Company:

An over-capitalised company may suffer from the following ill consequences or disadvantages:

(i) The shares of the company may not be easily marketable because of reduced earnings per
share.

(ii) The company may not be able to raise fresh capital from the market.

(iii) Reduced earnings may force the management to follow unfair practices. It may manipulate
the accounts to show higher profits.

(iv) Management may cut down expenditure on maintenance and replacement of assets. Proper
amount of depreciation of assets may not be provided for.

(v) Because of low earnings, reputation of the company would be lowered.

Effects of Over-capitalisation on Shareholders:

Over-capitalisation is disadvantageous to the shareholders because of the following reasons:

(i) Over-capitalisation results in reduced earnings for the company. This means the shareholders
will get lesser dividend.

(ii) Market value of shares will go down because of lower profitability.

(iii) There may be no certainty of income to the shareholders in the future.

(iv) The reputation of the company will go down. Because of this, the shares of the company may
not be easily marketable.

(v) In case of reorganisation, the face value of the equity share might be brought down.

Effects of Over-capitalisation on Society:

The effects of over-capitalisation on the society are as follows:

(i) The profits of an over-capitalised company would show a declining trend. Such a company
may resort to tactics like increase in product price or lowering of product quality.

(ii) Return on capital employed is very low. This means that financial resources of the public are
not being utilised properly.

(iii) An over-capitalised company may not be able to pay interest to the creditors regularly.
(iv) The company may not be able to provide better working conditions and adequate wages to
the workers.

Remedies for Over-capitalization:

In order to correct the situation caused by over-capitalisation, the following measures should be
adopted:

(i) The earning capacity of the company should be increased by raising the efficiency of human
and non-human resources of the company.

(ii) Long-term borrowings carrying higher rate of interest may be redeemed out of existing
resources.

(iii) The par value and/or number of equity shares may be reduced.

(iv) Management should follow a conservative policy in declaring dividend and should take all
measures to cut down unnecessary expenses on administration.

Over- Capitalization and Under Capitalization of Company!

The capital structure of a company should be fair, neither overcapitalized, nor undercapitalized.
The availability of funds should be neither too much nor too low.

Over- Capitalization:

A company is said to be over-capitalized when its earnings are not sufficient to justify a fair
return on the amount of capital raised through equity and debentures.

It is said to be over capitalized when the total of owned and borrowed capital exceeds its fixed
and current assets. This happens when it shows accumulated losses on the assets side of the
balance sheet.
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.

Causes of Over Capitalization:

The important reasons of over-capitalization are:

1. Idle funds:

The company may have unused funds lying idle in banks or in the form of low yield investments,
and there is no likelihood of using it properly in the near future.

2. Over-valuation of acquired assets:

The fixed assets, particularly goodwill, might have been bought at a much higher cost than
warranted by the services to be rendered.

3. Fall in value of fixed assets:

Fixed assets might have been acquired at a time when prices were high and now the prices have
corrected substantially. But in the balance sheet the assets are yet shown at their book value less
depreciation written off.

4. Inadequate depreciation provision:

If proper and adequate depreciation has not been provided on the fixed assets the result would
be more profits in the Profit & Loss Account. This book profit might have been distributed as
dividend and leaving no funds with which to replace the assets at the right time.

Remedies of over-capitalization:

The process of remedying overcapitalization is very painful. It can be remedied through following
measures:

1. Reduction in its capital so as to obtain a satisfactory relationship between proprietary funds

and net profit.

2. If over-capitalization is because of result of over-valuation of assets then it can be remedied by

bringing down the values of assets to their proper values.

3. Reduction of debt burden. For which negotiations with the big lenders may be made to reduce
the interest obligation.

4. Preference shares may be redeemed through capital reduction scheme.

5. Reducing face value and paid up value of equity shares.

6. Initiating merger with well managed profit making companies interested in taking over ailing
company.

Many Indian companies have resorted to remedying overcapitalization through the measures
mentioned above.

Under- Capitalization:

If the owned capital of the firm is disproportionate to the size of business operations and the
firm has to depend upon borrowed money and trade creditors it is a sufficient indicator of
undercapitalization. It may also be because of over-trading, trading beyond capacity. It must be
noted that undercapitalization is different from high capital gearing.

In capital gearing there is a comparison between equity capital and fixed interest bearing capital
(which includes preference share capital and excludes trade creditors) whereas in the case of
under capitalization, comparison is made between total owned capital (both equity and
preference share capital) and total borrowed capital (which includes trade creditors as well).
Under capitalization is signaled by low proprietary ratio, high current ratio, and high return on
equity capital.

Causes of Undercapitalization:

1. Under-estimation of future earnings in the beginning and also later stages of the company.

2. Extraordinary increase in earnings.

3. Lower estimation of total fund requirements.

4. Being highly efficient through improved technology.

5. Companies established during recession make higher earnings as and when the recession is
over.

6. Companies following conservative dividend policy will in due course find themselves gradually
rising profits.

7. Purchase of assets at exceptionally low prices.

How does Undercapitalization affect?

Undercapitalization affects different stakeholders in the different ways:

Firm:

Undercapitalization brings in greater reputation, greater earnings and greater market share.
Higher rate of return leads to higher competition in the market. Higher profit means better
products to follow. There would be excessive interest on borrowed capital. However, the
employees would demand higher salaries, and the government may impose heavy tax.

Shareholders:

Due to increase in market share and profitability, the company enjoys better reputation. The
company's equity shares valuation goes up in the stock market. The shareholders can expect
better dividends.

Consumers:

Consumers often feel that they are being overcharged, and thus feel being on the receiving end.

Society:

High earnings, high profitability, and high market valuation of shares affects society in an adverse
manner. Public feels being overcharged on the one hand, and expects such firms to raise
innovations, on the other. In the stock market for such firms often unhealthy things get into
currency.

Remedies of undercapitalization:

1. To reduce the dividend per share split up at the shares; Many Indian companies, including
Luxmi Machine Works, have done it.
2. Issue of bonus share will reduce both the dividend per share and earnings per share.

Undercapitalization and Overcapitalization - Both are bad!

The conclusion is that neither undercapitalization, nor overcapitalization is desirable, as both are
evils. However, if one has to choose between the two, undercapitalization would be the right
choice:

(a) Overcapitalization leads to the conclusion that capital is ineffectively used and the earnings
are less than being fare.

(b) Undercapitalization, whereas, means that the rate of profit on capital invested is higher than
the normal return (enjoyed by similar companies in the same industry or when the value of
assets is more than the amount of capital).

(c) Undercapitalization has its own evil consequences but it is not as fatal as in the case of over
capitalization. Undercapitalization cannot continue indefinitely because more profitability means
more competition, more government intervention, and the environment pulls and pressures.

(d) Overcapitalization being a serious problem, later or sooner the company will have to be
reorganized and the consequences of the same will have to be borne by the shareholders and
creditors.