This article will help you to make comparison between over-capitalisation and under-capitalisation.
Comparison # Over-Capitalisation:
This state of affairs for a concern occurs where the amount of the shares issued is much in excess of actual requirement, and thus the rate of profit, i.e., the dividend rate will be too low to allow the shares to sell at par value. This means the funds invested in the concern are not profitably employed and the enterprise cannot pay fair return on its capital investment.
Over-capitalisation is resulted because of following reasons:
(i) Concern may raise more money by issue of shares and debentures than it can use fully and profitably.
(ii) Concern may borrow large sum of money than desired and hence a major part of the earnings may be given away to the creditors and left very little for the shareholders.
(iii) Sometimes company purchases plant, machinery or building etc. during its peak of prosperity. But when slumps set in, the books show the assets and capital at high value, even when large amount of working capital is lost. Thus the value of assets falls, whereas the capital stands at its original figure.
(iv) If a company does not make sufficient reserves for depreciation and equipment replacement, then after sometime although capital value as per book is sufficient but the company is not having money for equipment replacement.
Disadvantages:
Following are the disadvantages of over-capitalisation:
1. When shares sell below par value, company suffers a fall in its credit, hence it becomes difficult to raise further capital for extension and improvement.
2. To cover up the lack of profit other methods have to be adopted, which will lead to poor quality, rise in products price.
3. It is a wastage (or misapplication) of country’s resources.
4. There will be loss of capital and loss of income to the shareholders. Because if the shareholders sell their shares then they have to suffer a heavy loss (as these shares cannot give good return) and if they continue to hold these shares, there will be hardly any dividends.
5. Due to low profits, welfare facilities and good wages cannot be given to the workers which will further increase inefficiency.
6. Because of the higher rates, poor quality and low share value, company will have poor reputation in the public.
Comparison # Under-Capitalisation:
Under-capitalisation means insufficiency of the capital required to meet the total needs of the concern. Thus due to financial weakness under-capitalisation is resulted. This results a condition when unusually large return is earned on total investment. Main reason for the under-capitalisation is wrong estimation of capital needs and the failure of the promoters to raise the required capital. It faces the danger of going out of business.
For removing under-capitalisation, capital has to be borrowed at high rates from other sources. The money borrowed at high rate of interest is always a source of trouble, as it affects adversely on industrial growth, it tends to increase the price of the product and reduces profit.
Generally experienced and highly qualified persons, when start their business without their own capital, face the trouble of under-capitalisation and ultimately face the liquidation.
Hence as a remedy to it, following precautions should be taken: purchase the product on long term credit, sell the product quickly and collect their money promptly, keep minimum stock, and pay small dividends. It means every efforts must be taken to increase the working capital.
Thus it has been observed that under-capitalisation is a lesser evil as it can be corrected in an easier way by increasing the amount of debentures or shares.