After reading this article you will learn about over and under capitalisation of a company.
Over-Capitalization of a Company:
An over capitalized firm can be compared to a (fat) man who has got fat more than required and suffers from variety of diseases. Over-capitalization implies that the total capital of the company (owned capital plus borrowed capital) is in excess of the level of proper capitalisation.
The level of proper capitalisation is the requirements of the company which can be considered to be just appropriate. Whether the requirement is appropriate or inappropriate, it can be determined on the basis of the earning capacity of the company.
If the earning capacity of the company has gone down (due to internal or external factors), a state of over-capitalisation exists. Thus, a company is said to be over-capitalized, when its earnings are not large enough to yield a fair return on the amount of stocks and bonds that have been issued. Or, when the amount of securities outstanding, exceeds the current value of assets.
Also, when a company has consistently been unable to earn the prevailing rate of return on its outstanding securities (considering the earnings of similar companies in the same industry and the degree of risk involved), it is said to be over-capitalized. Over-capitalization does not necessarily mean abundance of capital.
Causes of Over-Capitalization:
(i) More shares and/or debentures might have been issued, resulting in availability of surplus funds that cannot be profitably employed, but dividend shall have to be paid on such excess capital also.
(ii) Rate of interest on borrowings might be higher than the rate of earnings of the company.
(iii) Wrong estimate of the earnings of the company. If future earning is over-estimated, the market value of shares will fall below the purchase price because shareholders will not get what they had been promised by the company.
(iv) Floating the company under inflationary conditions will lead to over-capitalisation because of purchase of assets at high prices.
(v) Payment of high promotional expenses, i.e., if the remuneration paid to promoters etc., is very high.
(vi) Provision of depreciation lass than justified. So company will find it difficult to replace the assets (machinery etc.) with the funds made available by depreciation provision.
(vii) Insufficient and extravagant management of the company. Liberal payment of dividend and low retention of earnings for self-financing.
(viii) Time lag between installation of machinery and starting production.
(ix) High tax rates and excessive tax payment also results in over-capitalisation.
Effects of Over-Capitalization:
(i) Less earnings of the company, leading to reduction of rate of dividend and hence decrease in market value of its shares.
(ii) Shareholders of the company get less dividends.
(iii) Employees are denied increase in salaries.
(iv) Prices of company products may go high.
(v) Company finds it difficult to raise capital, because in present situation of over-capitalisation, it finds it difficult to pay a fair rate of return to its investors.
(vi) To save their skin, directors of the company may resort to unfair practices like manipulation of the books of accounts to show artificial prosperity.
Remedial Measures to Correct Over-Capitalization:
(i) All avoidable costs should be avoided e.g., purchase of new vehicles, air-conditioners, sophisticated office furniture etc.
(ii) Wastage and extravagance should be avoided.
(iii) Earning capacity should be increased by minimizing scrap and by increasing efficiency of workers.
(iv) The par value of shares or the number of shares may be reduced (to eliminate watered stock).
(v) Debentures and cumulative preference shares carrying higher rate of interest and dividend should be redeemed or their holders may be persuaded to take new debentures at lower rate of interest.
Under-Capitalization of a Company:
Under-capitalization is reverse of the over-capitalization. A corporation may be under-capitalized when the rate of profits it is making on the total capital is exceptionally high, in relation to the return enjoyed by similar situated companies in the same industry, OR, When it has insufficient or too little capital to conduct its business.
Causes of Under-Capitalization:
(1) A company which is floated during depression will find itself under-capitalized during boom period. The reason being that the assets were acquired at lower cost and the return during inflation will be high.
(2) If the company is working at a high degree of efficiency it will earn more profits which will push up the real value of the shares in the market, indicating under-capitalisation.
(3) The promoters of the company at the time of preparing financial plan may under estimate future earnings or make under-estimation of capital requirements.
If the earnings, later on, prove to be higher than the estimated figure, the company will become under-capitalized.
(4) The company may follow a conservative dividend policy (i.e., moderate rate of dividend) thereby leading to enough funds for business expansion, machinery replacement etc. This will lead to higher rates of earnings and hence under-capitalisation.
(5) The promoters of the company in a desire to keep control over the affairs of the concern may issue lesser number of shares and prefer to manage with their own capital or through cheap borrowings and retained earnings, it may lead the company to under-capitalisation after some time.
Effects of Under-Capitalization:
(1) Seeing the high rate of earning and profits of the company, the employees/workers shall start demanding high salaries.
(2) High profits of the company may encourage others to enter the same business line leading to sever competition.
(3) Customers may feel that they are being exploited by the company.
(4) Company will have to pay more taxes.
Where under-capitalization arises due to inadequacy of funds:
(5) At times, company may be compelled to raise funds at higher rates of interest.
(6) Due to inadequacy of capital, once the company runs into rough weather, it may lack working capital and hence a constant danger of failure of business.
Remedial Measures to Control Under-Capitalization:
(1) The existing shareholders may be allotted shares of higher face (par) value in exchange for the old shares. This procedure will bring down the rate of earning per rupee of share value but will not affect the amount of dividend per share.
(2) The shares may be splitted up. It has the effect of reducing the dividend per share. In other words, the par value of shares may be reduced by sub-dividing the shares.
(3) The management may issue bonus shares to equity shareholders. This measure shall capitalize the earnings/products, thus increase the capitalisation and the number of shares. Dividend per share and rate of earnings will be reduced.
(4) To remove the state of under-capitalisation, fresh (more) shares and debentures may be issued.