(ii) Investors’ confidence in the company is lost; as to them, the future of the company seems to be gloomy and uncertain. (iv) The company may not be able to provide better working conditions and adequate wages to the workers. (v) In case of reorganisation, the face value of the equity share might be brought down. (iv) Management may cut down expenditure on maintenance and replacement of assets.
For example, a company’s earning was estimated at Rs. 10,000 and the industry average rate of return was fixed at 8 percent. A mistake in initial estimate of earnings may subsequently land a corporation into over-capitalisation since capitalisation based on such an estimate is not justified by income which the firm actually earns. For example, a company’s initial earning was estimated at Rs. 10,000 and industry’s average rate of return was fixed at 12 percent.
Working Capital Management
Thus, comparison of book value with real value of share is the most satisfactory criterion to test the state over capitalization. Excess of capital may be one of the reasons for over-capitalization. Inadequate capital is typically the result of poor financial planning, which forces the business to borrow money at exorbitant interest rates. In this instance, a significant portion of profits is paid as interest to the creditors, leaving little money for dividends to be paid to the shareholders. The market value of shares also decreases due to the dividend rate falling, which is a sign of overcapitalisation.
According to Bonneville, Dewey and Kelly, when a business is unable to earn a fair rate of return on its outstanding securities, it is over capitalized. Thus over capitalization refers to that state of affairs where earning of the corporation do not justify the amount of capital invested in the business. The main symptom of over capitalization in a company is the amount of earning which it is making on its total capital.
- Management should try to become more efficient and try to curb excess expenditure.
- A business can plan according to its expansion and growth needs.
- This excess capital can be in the form of debt, equity, or a combination of both.
- Effects of over-capitalisation are so grave that the management should take immediate measures to remedy the situation of over-capitalisation as soon as the symptoms of the over-capitalisation are observed.
- One common cause for overcapitalization is acquiring assets at inflated prices.
Policies purchased when premiums are low can reduce an insurance company’s profitability. Learn about overcapitalization in finance, including its definition, causes, and an example. Understand the impact of excessive capital investment in businesses. For example, if a firm earns a profit of Rs. 1 lakh and the expected rate of earnings is 10% the maximum amount of capitalization is Rs.10 lakh.
FAQs About the Overcapitalization and Undercapitalization
The term “capitalisation” in corporate finance refers to a firm’s total holdings of debt and equity. As a result, it defines the entire amount of capital spent in the business. By doing so, Infosys aims to return excess capital to shareholders, enhance earnings per share (EPS), and maintain a more efficient capital structure. These buybacks are part of Infosys’ broader capital management strategy to strike a balance between financial stability and shareholder value creation. If a business does not retain sufficient profits for internal growth, it will need to borrow more money. It means excessive dividend payments can also lead to the overcapitalization of a company in the long run.
The Importance of Emergency Funds and How to Build Yours
‘Watered capital’ must be distinguished from over capitalization. Water enters the capital usually in the initial period-at the time of promotion. Over capitalization can, however, be found out only after the company has worked for some time. Although watered capital can be a cause of over capitalization, yet it is not exactly the same thing.
However, considering the evils of over-capitalisation, the right remedial measure should be adopted. In case the capital is inadequate due to inaccurate planning, then the firm has to depend on borrowings from external sources at high rates of interest. Working efficiency is affected adversely because of a shortage of capital.
In short, over-capitalization is a situation when the profitability of a firm does not justify funds raised/borrowed. This situation signifies when part of the funds remains unutilized or idle. The cost theory of capitalization is useful for those firms in which the amount of fixed capital is more and whose earnings are regular, such as construction and public utility concerns. When a corporation is overcapitalised, it has extra cash or capital on its balance sheet that it can deposit in the bank and earn a nominal return on, improving its liquidity situation.
If a new firm is formed by converting partnership or private firms, assets are transferred at inflated prices. These assets do not give commensurate returns or contribute to the earning capacity of the firm. When the causes of over capitalisation promoters or managers incorrectly overestimate the company’s earnings, this will lead to overcapitalisation because it won’t produce a fair rate of return that is common in the market. Everybody knows that having too much of anything is wrong, and the financial world is no exception.