Paucity of capital is also one of the causes of over-capitalisation. Inadequacy of capital is, generally, the result of faulty financial planning, and compells the company to borrow capital at very high rates of interest. In this case, a large chunk of profits is given away to the creditors as interest leaving little to be distributed to the shareholders as dividends. Due to fall in rate of dividend, the market value of shares also fall which is the symptom of over-capitalisation.

Providing inadequate depreciation results in over-capitalisation causes of over capitalisation as it leaves insufficient provision for replacement of assets. It promoters buy assets of lower values at higher prices, they are led to a situation of over-capitalisation because assets of lower value will be shown at higher value in the Balance sheet. As a result of this, earning per share tends to go up by the same proportion. This, in turn, may help the company to improve its credit position in the market and its share values consequently may soar.

(ii) Long-term borrowings carrying higher rate of interest may be redeemed out of existing resources. (c) A part of the capital is either idle or invested in assets which are not fully utilised.

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This malpractice further adds to the losses of the shareholders. For a company faced with a situation of over-capitalisation, it is very difficult to obtain further capital for its growth and expansion programmes. It is so because the investors have already lost confidence in the company. It may be noted that over-capitalisation is not exactly the same as excess of capital. Abundance of capital may be one of the reasons of over-capitalisation but it is not the only reason.

Effects of Overcapitalisation

Capitalization is a term used in corporate finance to describe the total amount of debt and equity held by a company. As such, it defines the total amount of money that is invested in the company itself. Shweta Desai is a personal finance enthusiast dedicated to helping readers make sense of money matters.

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It may be due to overestimation of capital project costs or overambitious planning. Either way, excessive capital funding is the main reason behind the overcapitalization of a business. Another clear indicator of a business in such a situation is a troubled working capital. Often, a business overestimates its working capital requirements and arranges excessive capital investment.

In other words, a company is said to be over-capitalised when it is not able to pay interest on debentures and loans and ensure a fair return to the shareholders. A company right from its incorporation falls prey to overcapitalization if it has been established with assets acquired at higher prices which do not bear any relation to their earning capacity. Relax Steel Ltd has earned net profit of Rs. 2 lakhs in the last financial year of 2006. The total amount of equity share capital of the company is Rs. 18 lakhs and total assets amount to Rs. 30 lakhs. If the establishment of a new company or the expansion of an existing concern takes place during the boom period, it may be a victim of over- capitalisation. But when boom conditions cease prices of products decline resulting in lower earnings.

Consequently, they might be compelled to issue large stock to raise the money. This, instead of remedying the problem, might aggravate it. We shall now examine efficacy of each of these measures as curative to the problem of over-capitalisation. Secondly, these companies may, in times of necessity, be compelled to take recourse to costlier borrowing which, in turn adversely affects their earning position. The combined effects of these may land these companies in state of over-capitalisation.

It means it is the opposite situation of overcapitalization. The rate of return falls because ABC company produced the same profit using more capital resources than it required. If ABC uses more capital than its fair capital requirement of $ 2 million, it will be considered an overcapitalized firm. Suppose it has invested $ 2.5 million in total capital investment. A business can end up with excessive capital funding due to several reasons.

  • As a result of this, earning per share tends to go up by the same proportion.
  • An increased cost of interest would keep working capital management under constant pressure that will result in further borrowings.
  • Moreover, a firm is said to be overcapitalised if it cannot pay the interest on its long-term debt and debentures and the fair dividend rates on its shares.
  • Thus, shareholders have to suffer a loss in capital due to depreciation of their investments.

Overcapitalization Examples

(i) The shares of the company may not be easily marketable because of reduced earnings per share. Likewise, an over-capitalised company must cut its dead weight before it becomes deep rooted and almost impossible to get rid of. The evil effects of over-capitalisation are so grave that the management must take remedial measures to rectify the situation as soon as the first symptoms of over-capitalisation are observed by the firm. An over­-capitalised company has been rightly compared with a very fat person who is likely to suffer from various diseases unless he takes steps to immediately reduce his weight. If a company’s products register a constant decline, it will bring down the profitability of the concern and as a result, returns on capital employed will be reduced which represents over-capitalisation. High rates of taxation may leave little in the hands of the management to provide for depreciation, replacements and dividends.

Causes of Overcapitalisation

Defective financial planning may lead to excessive issue of shares or debentures. The issue would be superfluous and a constant burden on the earnings of the company. Market capitalization refers to the total dollar value of a company’s outstanding shares. You can easily calculate this figure by multiplying the price of one share by the total number of shares outstanding.

  • This problem typically occurs when a business raises more money than its actual earnings can support.
  • Insufficient provision for depreciation consumes unnecessary profits and reduces the overall earning capacity of the company.
  • In this case, the company ends up paying more interest and dividends, which is impossible to sustain in the long term.

In order to prevent declining trend of income, an over-capitalised concern resorts to increased prices and reduction in quality of its products.. Hence, consumers have to suffer by paying more for the poorer quality. The shares of an over-capitalised company have small value as collateral security. Banks and other financial institutions are reluctant to lend money against such securities. Hence, it is very difficult for the shareholders to borrow money against the security of their shares. Over-capitalisation refers to that state of affairs where earnings of a company do not justify the amount of capital invested in its business.

Similar question arises in the event of amalgamation, merger or reorganization of companies. Just like overcapitalization, being undercapitalized is not where any company wants to be. The excess capital also means that the company has a higher valuation and can claim a higher price in the event of an acquisition or merger. Additional capital can also be used to fund capital expenditures, such as R&D projects. Remedies have their own diffi­culties and their applications also depend on the shareholders, debenture-holders as the case may be. However, considering the evils of over-capitalisation, the right remedial measure should be adopted.