(iii) Reduced earnings may force the management to follow unfair practices. Inefficient management and extravagant organisation may also lead to over-capitalisation of the company. An over-capitalised company tends to reduce wages and welfare facilities of the workers to reduce losses of the earnings.
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In order to prevent declining trend of income, an over-capitalised concern resorts to increased prices and reduction in quality of its products.. Hence, consumers have to suffer by paying more for the poorer quality. Over-capitalisation refers to that state of affairs where earnings of a company do not justify the amount of capital invested in its business. Over-capitalized concerns, more often than not, fail to make regular payments of interest and repay principal money on stipulated date. Under the situation creditors may demand liquidation of reorganization of company. Profits are high in such companies and a part of the profits are plowed back into the business directly or indirectly.
Corrective Measures to Limit the Negative Effects of Overcapitalization
Another clear indicator of a business in such a situation is a troubled working capital. Often, a business overestimates its working capital requirements and arranges excessive capital investment. One reason and an indicator of a business facing such a scenario is to pursue a large and liberal dividend policy. These businesses do not retain sufficient cash and issue large dividends instead. Stressed working capital due to excessive borrowings and increased interest costs would mean lower profits for the company.
- If sufficient provision is not made for the depreciation of an asset, the result is that adequate funds are not available when the asset has to be replaced or becomes obsolete.
- This may cause serious problem to the firm subsequently when it experiences shortage of funds to meet emergent requirements compelling the firm to procure necessary funds at unreasonably high rate of interest.
- Identifying the causes and implementing appropriate remedies is essential to restore the company’s financial health and competitiveness.
- Thus, a company is in state of over-capitalisation when book value of its shares exceeds the real value.
- Undercapitalization occurs when a company has neither sufficient cash flow nor access to the credit it requires to finance its operations.
- The company might incur heavy preliminary expenses such as purchase of goodwill, patents, etc.; printing of prospectus, underwriting commission, brokerage, etc.
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On the other hand, over-capitalisation may occur when the amount of shares debentures, public deposits and loans exceed the current value of the assets. 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. Secondly, these companies are also not capable of providing as much facility to their customers as their competitors could with the result that they fail to maintain their customers. Inventories lie in store for pretty long time and substantially large amount of capital is unnecessarily tied up in them. Thus, a company is in state of over-capitalisation when book value of its shares exceeds the real value.
Formation During Boom Period
Overcapitalisation has many negatives, including poor credit worthiness, reduced dividend rate, loss to shareholders and creditors, and recession. Shareholders are burned twice as much by overcapitalisation, and they cannot profitably sell their holdings due to a decline in the market value of shares. On the other hand, not only does their dividend income decline, but the certainty of its receipts also does. They start to feel that shaky foundations support the company. In short, a firm will be seen to be overcapitalised if it cannot obtain a reasonable or prevailing rate of return on its capital. As a result, the market value of its shares has consistently fallen below the book value over time.
To determine the amount of capitalization, a new firm will have to estimate the average annual future earnings and the normal rate of earnings (also known as capitalization rate) prevalent in the industry. Poor corporate management, higher-than-expected launch expenditures, which sometimes show up as assets on the balance sheet, and changes in the business environment are some of the causes. Overcapitalisation can also result from underutilising resources. If ABC uses more capital than 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.
Book value of shares represents the value which is obtained by dividing the sum of capital stock and surplus accounts of the company by the number of shares outstanding. Over-capitalized companies desirous of increasing their earnings would unjustifiably raise the price of their products and ignore or lower the quality of the goods. It is desirable to correct overcapitalization by reducing long-term debt. The debentures and bonds should be redeemed to restore parity between the book value of the company and its real value. True reduction of capitalization would be affected if the debt is retired from earnings.
Sometimes, shareholders may oppose to this proposal but actually causes of over capitalisation 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. Thus, we see that as a result of over-capitalisation, the rate of earnings has dropped from 10% to 8⅓%.
