Skip to content

What is Over Capitalization? MBA Knowledge Base

  • by

causes of over capitalisation

11 Financial may only transact business in those states in which it is registered, or qualifies for an exemption or exclusion from registration requirements. 11 Financial’s website is limited to the dissemination of general information pertaining to its advisory services, together with access to additional investment-related information, publications, and links. Unless countermeasures are adopted to combat obesity, the situation is dire for such an individual. Companies may also find themselves at risk of becoming overcapitalized when they either mismanage or underutilize the capital they have. Heavy expenditure of promotion and high price of patent, goodwill causes of over capitalisation etc. Follow Khatabook for the latest updates, news blogs, and articles related to micro, small and medium businesses (MSMEs), business tips, income tax, GST, salary, and accounting.

We may earn a commission when you click on a link or make a purchase through the links on our site. All of our content is based on objective analysis, and the opinions are our own. One of the largest banks in India stated that they were “an overcapitalised firm as of now (2017)” in a conversation with ET Now. The only effective remedy to cure over-capitalisation lies in implementing a scheme of a capital reduction. (ii) Long-term borrowings carrying higher rate of interest may be redeemed out of existing resources.

Working Capital Issues

In this case, shares are neither issued on premium nor at discount. Par value is static in character that remains unaffected by business oscillations. While investing money in existing ventures investors are interested to know whether company in question is over-capitalized or not. Similar question arises in the event of amalgamation, merger or reorganization of companies. Undercapitalization is just the reverse of over-capitalization. The state of under-capitalization is where the value of assets is much more than it appears in the books of the company.

Solutions for Overcapitalization

Thus, shareholders have to suffer a loss in capital due to depreciation of their investments. This means that the company’s earnings are generated only from Rs. 15,00,000 worth of assets, while it has a capitalization of Rs. 25,00,000. The excess capital, in this case, represents idle funds that do not produce any benefits or profits for the company. When a company is overcapitalized, its market value is less than its total capitalized value or its current value. An overcapitalized company may end up paying more in interest and dividend payments than it can sustain in the long term.

causes of over capitalisation

Table of Contents

As, shareholders are the real owners of a company, they suffer most on account of over-capitalisation. Providing inadequate depreciation results in over-capitalisation as it leaves insufficient provision for replacement of assets. There are many factors which account for the situation of over-capitalisation of a company.

In this situation, a significant proportion of capital is idle or inefficiently used. As a result, the company’s earnings shrink, which causes its stock’s market value to decrease. Inadequate working capital resources such as lower cash levels will lead to working capital management issues. Stressed cashflows in working capital would require excessive capital investments. One common cause for overcapitalization is acquiring assets at inflated prices.

Capitalization of interest results in lower interest expenditure, somewhat higher depreciation, higher operating cash flow, and a higher interest coverage ratio. Financial statements are frequently changed by analysts to eliminate the consequences of capitalized interest. If the estimated earnings are lower, the capitalization figure is also lower. Sometimes, the earning prove to be much higher and the capitalization figure previously calculated is lower. If the earning is not estimated correctly, the amount of capitalization would be misleading. ‘Water’ is said to be present in the capital when a part of the capital is not represented by assets.

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. In an over-capitalised company, there is a reduced earning capacity resulting in the fall of market price of its shares and thereby shaking up the investor’s confidence. A company whose shares sell below the face value may find it difficult to improve its goodwill in the market. Many companies prefer to declare a higher rate of dividend instead of retaining a part of the profits and ploughing them back or reinvesting them. Such a practice should be discouraged as it leads to over-capitalisation, because liberal dividends are paid at the cost of inadequate provision for depreciation.

Defective financial planning may lead to excessive issues of shares or debentures. The issue would be superfluous and a constant burden on the earnings of the company. 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. 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.

Working Capital Management

  1. In fact, in actual practice, many over-capitalised companies have been found to be short of funds.
  2. Truly speaking, over- capitalisation is a relative term used to denote that the firm in question is not earning reasonable income on its funds.
  3. It estimates significant growth and overestimates its capital requirements.
  4. Thus, their rate of return reduces from 20% to 16% due to overcapitalization.

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. Low rate of earnings and reduced dividends cause fall in the market value of shares of the over-capitalised company.

Leave a Reply

Your email address will not be published. Required fields are marked *

جميع الحقوق محفوظة لشركة نجم الشمال للاستشارات الهندسية و التدريب 2023