Overcapitalization: Definition, Causes, and Example

As against this, amount of reserves and surplus of firm enters into calculation of book value of shares. Choice of book value, therefore, appears to be relatively more logical. As for market value, there is no doubt that present condition of a firm is reflected in market value of its share. Join us as we unravel the complexities of overcapitalisation and its implications for businesses.

Causes and Effects of Overcapitalization

If, with the agreement with and consent of the equity shareholders, number of equity shares can be reduced, over-capitalisation can also come down. Of course, the shareholders must be convinced that their interest in the company will not be adversely affected. In the present day times, the corporate taxes are quite high.

As against this, others are of the view that to test the state of over-capitalisation comparison between book value and real value of shares should be made. Where book value of shares is higher than the real value, company, according to them, would be over-capitalized. To understand the concept of over-capitalisation, it would be necessary to have clear view of different values of shares. “A certain degree of over­capitalisation ,”says Beacham, “may be caused by heavy issue expenses”.

Taxation policy:

Consequently, the company is unable to distribute dividends at prevailing rates. The leads to decline the market value of its shares which a symptom of over-capitalisation. Company may be over capitalised if it has paid high promotional expenses in the form of payments to promoters for their services, and excessive price for goodwill, trade marks, causes of over capitalisation patents, copyright, etc.

Certain companies do not believe in making adequate provision for various types of reserves and distribute the entire profit in the form of dividends. Such a policy reduces the real profit of the company and the book value of the shares lags much behind its real value. Absence of suitable depreciation policy would make the asset-values superfluous.

• Lowered earnings bring about fall in share values, which represents over-capitalisation.
• For a company faced with a situation of over-capitalisation, it is very difficult to obtain further capital for its growth and expansion programmes.
• In its desperate bid to regain its lost confidence over-capitalized concerns have been found manipulating books of accounts to show inflated profits.

On Company:

It may be noted that over-capitalisation does not necessarily mean abundance or excess of capital. Company may be over-capitalised because its capital is not effectively utilised, thus causing a constant decline in earnings. This leads to the inability of the company to pay normal rate of dividend and interest on shares and debentures respectively, and the .consequent fall in the market value of its shares. A company is said to be over-capitalised when its earnings are consistently insufficient to yield a fair rate of return on the amount of capitalisation. In other words, when a company is not in a position to pay interest on debentures and long-term borrowings, and dividends shares at fair rates, it is said to be overcapitalised.

A high amount of preliminary expenses may cause overcapitalization. Over-capitalization is a financial condition that can have significant negative consequences for a company and its stakeholders. Identifying the causes and implementing appropriate remedies is essential to restore the company’s financial health and competitiveness. (a) The amount of capital invested in the company’s business is much more than the real value of its assets. Another social evil of over-capitalisation is promotion of gambling habits by providing scope for gambling in shares of such a company.

Identifying the signs of overcapitalisation and taking corrective measures is essential for maintaining a healthy financial structure. 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.

The original value of assets remains in books while earning capacity dwindles due to depression. Overcapitalization happens when a company’s debt and equity values are higher than those of its total assets. This means that its market value is less than its capitalized value. Companies that are overcapitalized may have trouble getting more financing or may be subject to higher interest rates. They may also have to pay more in dividends than they can sustain over the long run. Overcapitalisation can be detrimental to a company, including reduced return on investment, lower profitability, and an inefficient allocation of resources.

Lower Profitability

It may require substantial capital investment for working capital or capital investment projects. However, inaccurate forecasting and other reasons may lead a business to excessive capital. Overcapitalization may result in a decline in the earnings capacity of the company which may consequently lead to fewer profits & lesser dividends.

How Does Overcapitalization Work?

This will adversely affect earnings capacity and thus leads to over-capitalisation. In terms of earnings, over-capitalisation arises when the earnings of the company are not sufficient to give a normal return on capital employed by it. Thus, through simple process of accounting, condition of over-capitalisation can be converted into that of undercapitalization. But it would be difficult to convince the shareholders in this respect. They may believe it to be management trick to dupe them by giving them lower par value stock in exchange for higher value stock though in fact real value of shares is in no way affected.

(i) Over-capitalisation results in reduced earnings for the company. Over-capitalisation arises when the existing capital of a firm is not effectively utilised with the result that there is a fall in the earning capacity of the company. Thus, the main sign of over-capitalisation is fall in the rate of dividend and market value of shares of the company in the long-run. By reducing number of outstanding shares, efforts are made to correct the outward symptoms of overcapitalization. For example, a company is capitalized with 10,000 shares of Rs. 10/- each. If the management decides to issue one new share in exchange of four old shares and shareholders agree to accept the decision, number of shares is reduced to 2,500.

Sometimes a company prefers to follow a liberal dividend policy instead of ploughing hack its profit. In the long-run, such company would find it difficult to replace its wornout assets with sufficiently decreased working efficiency. Moreover, the company is compelled to resort to costly borrowing which adversely affects its earning capacity. The combined effect of these factors leads the company to over capitalisation over a long period of time. Another reason for over-capitalisation is a lack of capital.

A business can plan according to its expansion and growth needs. A business can take a more calculated approach to avoid overcapitalization problems. Although it depends on the business size and future plans of a company, here are a few key steps to avoid such situations. A sudden change in the business environment due to a shift in the domestic, international or political environment may reduce the earnings of a company.

• Abundance of capital may be one of the reasons of over-capitalisation but it is not the only reason.
• They also suffer because capital invested by them in these companies depreciates due to fall in market value of their shares.
• This means that financial resources of the public are not being utilised properly.
• Market capitalization refers to the total dollar value of a company’s outstanding shares.
• To address overcapitalisation, companies may consider strategies such as returning excess capital to shareholders, retiring debt, or reinvesting in growth opportunities.

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. 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.

Increased Capital Investment

Overcapitalization is a financial situation where a company has more than enough total capital relative to the size of its activities. A high amount of preliminary expenses may be a reason for overcapitalization as they are shown as assets i.e. fictitious assets in the balance sheet. 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.