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