It is in this sense that the term ‘capitalisation’ has been used here. In the narrow sense, therefore, ‘capitalisation refers to the amount of capital represented by the capital stock, surplus and funded or long-term debts’. In a narrow sense, the term ‘capitalisation’ means the amount of capital at which the company’s business can be valued. Most of the traditional authors have defined the term only in this sense. Though this definition restricts its meaning only to the quantitative aspect, it is more specific.
- The key benefit of overcapitalization is that the company has sufficient funds to undertake expansions of its operations.
- (iii) Determining the composition or proportion of the various securities to be issued.
- Over-capitalisation refers to that state of affairs where earnings of a company do not justify the amount of capital invested in its business.
- Another aspect of capitalization refers to the company’s capital structure.
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. Undercapitalization occurs when a company has neither sufficient cash flow nor access to the credit it requires to finance its operations. The company may not be able to issue stock on the public markets because the company does not meet the requirements or because the filing expenses are too high.
Effects of Under-Capitalization
If sufficient provision is not made for the depreciation of an asset, the result is that adequate funds are not available when the asset has to be replaced or becomes obsolete. New assets at very high prices have to be purchased and the amount of capital invested is not justified and the firm may become over-capitalized. Floatation of a firm during a boom period leads to assets being acquired t inflated prices. But it is not able to increase its earnings accordingly and hence becomes over-capitalized. If a new firm is formed by converting partnership or private firms, assets are transferred at inflated prices.
Effects on Society
Under-capitalization is the reverse of over-capitalization. When the rate of earnings of a company is more than the fair or normal rate of earnings of that industry then the company is considered as under-capitalized. The par value of shares and debentures of an under-capitalized company is less than the true value of its fixed assets. The term overcapitalization refers to a situation wherein the value of a company’s capital is worth more than its total assets. Put simply, there is more debt and equity compared to the value of its assets. When a company is overcapitalized, its market value is less than its total capitalized value or its current value.
What is Capitalisation – Under Capitalisation: Meaning, Causes, Effects and Remedies
In some cases, an undercapitalized corporation can leave an entrepreneur liable for business-related matters. This is more likely when corporate and personal assets are commingled when the corporation’s owners defraud creditors, and when adequate records are not kept. An over-capitalised company has to often resort to reorganisation and reduction of its capital in order to write off the accumulated losses.
(b) Future earnings of the company were under-estimated at the time of promotion. (ii) The company has generated secret reserves by paying lower dividends to the shareholders over a number of years. A situation of over-trading by the company may arise as a result of under-capitalisation, where the company does excessive business than what its finances can allow.
It is a fine method if the equity shareholders are ready to give their consent to it. (a) Under capitalisation leads to unhealthy speculation on the stock exchanges, which affects investment climate adversely. (b) The value of long term assets is higher than capital raised. In order to overcome the situation of over capitalisation, the company may resort to any of the following remedial measures. (ii) The amount of capitalisation arrived at on the basis of earnings can be used as a standard for comparison. (ii) The amount of regular working capital to carry on business operations.
Thus, the essence of the above definitions is that capitalisation is the sum total of long-term securities issued by a company and the surplus not meant for distribution. (i) The total par value of all the securities -shares and debentures outstanding at a given time. Many authors regard Capitalisations as synonymous with financial planning. Broadly speaking, the term ‘Capitalisation’ refers to the process of determining the plan of financing.
In case of such companies, the dividend rate will be high and the market value of their shares will be higher than the value of shares of other similar companies. The state of under capitalisation of a company can easily be ascertained by comparing of a book value of equity shares of the company with their real value. In case real value is more than the book value, the company is said to be under capitalised.
The shortage of capital is also a contributory factor of over-capitalisation, the inadequacy of capital may be due to faulty drafting of the financial plan. Thus a major part of the earnings will not be available for the shareholders which will bring down the real value of the over capitalisation and under capitalisation shares. Over-capitalisation has nothing to do with redundance of capital in an enterprise. On the other hand, there is a greater possibility that the over-capitalised concern will be short of capital. The abstract reasoning can be explained by applying certain objective tests.
What Is Undercapitalization?
Sometimes, the terms watered capital and over-capitalisation are confused for each other, but it is not true. The concept of watered capital is confined to the time of promotion of the company. Under these circumstances, the existence of water in the stock cannot be ignored nevertheless the earning capacity of the enterprise may justify the payment at exorbitant price. Similarly, when an enterprise pays a higher price to the vendors for the assets transferred, the enterprise will be in the state of watered stock. (5) The company might have followed the lenient dividend policy without bothering much about building up the reserves.
In other words, the worth of a firm is not measured by the capital raised but by the earnings made out of the productive harnessing of the capital. The difference between capitalisation and capital structure should be noted. The term ‘capital structure’ refers to the form and proportion of various securities issued to raise the total amount.
An overcapitalized company may end up paying more in interest and dividend payments than it can sustain in the long term. Being overcapitalized means that a company’s capital management strategies are running inefficiently, placing it in a poor financial position. When the amount of share capital of a company is not represented by the same value of assets, rather that value is only shown in books, it is called watered capital. In such a situation, the realisable value of the assets is less than their book value.
(iii) Where under-capitalisation is due to insufficiency of capital, more shares and debentures may be issued to the public. There may be under-estimation https://1investing.in/ of capital requirements of the company by the promoters. This may lead to capitalisation which is insufficient to conduct its operations.
Generally, at the time of promotion of a company, the promoters are issued an excessive number of shares for their services. Another aspect of capitalization refers to the company’s capital structure. Capitalization can refer to the book value cost of capital, which is the sum of a company’s long-term debt, stock, and retained earnings. The market value cost of capital depends on the price of the company’s stock.
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