Over Capitalisation of a Company: Meaning, Causes and Effects

‘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.

Lower Profitability

A corporation will become overcapitalised if it borrows a significant amount of money at an interest rate higher than the pace at which its earnings grow. The dividend rate would logically fall, and the market value of the shares would decrease, as the creditors’ revenues would strip away a significant portion of its revenues as interest. Therefore, if the market price of the shares is below the book value, the firm is over-capitalised. Undercapitalized companies do not have sufficient cash reserve through retained earnings either. Due to their distressed financial situation, they cannot acquire external capital investment as well. An over-capitalised company will not be able to pay a fair rate of dividend to its shareholders because it is earning a low rate of return (earnings) on its capital.

• The main symptom of over capitalization in a company is the amount of earning which it is making on its total capital.
• A business can take a more calculated approach to avoid overcapitalization problems.
• In the long run, profits would get squeezed and the company will run out of liquidity as well.
• 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.

Causes of overcapitalisation

Over-capitalisation may be caused in a company if it raises excessive capital than what it can utilise effectively. In this case, a large amount of capital remains either idle or ineffectively utilised. Consequently, the   company’s earnings decline which lead to fall in market value of its shares. By its nature, inflationary conditions are an important factor in over capitalisation of business enterprises, and equally affect both the newly promoted as well as the established companies. During boom period, companies have to pay high prices for purchases of fixed assets, and the amount of capitalisation is kept high. Higher capitalisation is justifiable until inflationary conditions prevail.

• Join us as we unravel the complexities of overcapitalisation and its implications for businesses.
• This can lead to unutilized funds, which are unable to generate returns for the company.
• Secondly, market value of shares of a company is highly volatile.
• It can result from factors like overvalued assets, excessive borrowing, or overly optimistic growth expectations.
• This may adversely affect its earning capacity and lead to over-capitalisation.
• It is a financial situation where a company has more than enough total capital as compared to the needs of its business operations.

Overcapitalisation may also emerge from the government’s strict taxation policies. A sign of overcapitalisation is that the company has very little money left after paying higher taxes to distribute dividends to shareholders at the current rate. Additionally, the business can run out of money for working capital and funding to substitute and restore worn-out assets. As a result, the company’s productivity will decline, and the value of its shares will diminish. It is less the case with those contemporary financial instruments that are valued not for their returns, but for their potential earnings upon resale.

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. Overcapitalisation is a financial phenomenon that occurs when a company’s capital structure consists of an excessive amount of capital, often more than is required for its operations and growth plans. This surplus capital can negatively affect the corporation’s financials and profits and return on investment. By their very nature, inflationary conditions significantly contribute to the overcapitalisation of business enterprises and have an equal impact on newly developed and established businesses.

Overcapitalization would also mean investors and creditors would demand a higher rate of return. In the long run, profits would get squeezed and the company will run out of liquidity as well. It can lead to questionable and compromised sustainability of a company in the long run. Stressed working capital due to excessive borrowings and increased interest costs would mean lower profits for the company. The company will pay more on its debts than causes of over capitalisation it would earn otherwise.

The promoters or the directors of the company may over-estimate the earnings of the company and raise capital accordingly. If the company is not in a position to invest these funds profitably, the company will have more capital than required. The face value or the number of equity shares may be reduced in order to rectify over-capitalisation. Sometimes, shareholders may oppose to this proposal but actually their proportionate interest in the equity is not reduced.

Over-Capitalisation: Meaning, Effects and Remedies

Regularly monitoring and adjusting asset acquisitions to match the current demand can prevent overcapitalization. Conducting a thorough analysis of the business’s financial statements can identify the areas that require attention. Poor corporate management, higher-than-expected launch expenditures, which sometimes show up as assets on the balance sheet, and changes in the business environment are some of the causes. Overcapitalisation can also result from underutilising resources. (i) The shares of the company may not be easily marketable because of reduced earnings per share. The company may follow a liberal dividend policy and may not retain sufficient funds for self-financing.

Degraded earnings would hint towards the instability of business operations which may consequently lead to a downfall of share prices causing a ripple effect. Overcapitalization may occur when the return on investment earned by a company is exceptionally lower with respect to other similar companies in the same industry. Over-capitalisation leads to increased losses, poor quality of products, retrenchment or unemployment of workers, decline in wage rates and purchasing power of labour. This tendency gradually affects the entire industry and the society, and may lead to recession of economy. (iv) Loss on speculation, the prices of the shares of an over-capitalised company remain unstable because of speculative dealings in such shares.

In view of this, market value of shares of a company can at best be worked out by averaging out the market price of shares of the company ruling in the market over different dates. Thus, comparison of book value with real value of share is the most satisfactory criterion to test the state over capitalization. Overcapitalization can occur due to various reasons, resulting in a company having more capital investment than the actual requirement. This can lead to unutilized funds, which are unable to generate returns for the company. One reason could be an excessive expansion program, where a company stretches its investments beyond its own limits. Another possible cause could be the issuance of additional shares beyond the necessary requirement, leading to an increase in the firm’s equity base.

Pros and Cons of Overcapitalization

Businesses aim to produce earnings at a targeted level in the future. They can fund projects with debt and equity capital in anticipation of future earnings. In some cases, overestimation of earnings would also result in excessive capital investment and overcapitalization. Overcapitalization happens when a company’s debt and equity values are higher than those of its total assets.

In short, the capital which is not utilised properly, or remains idle, results in over-capitalisation. When the 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. If a corporation raises more capital than it can employ productively, overcapitalisation may result. In this situation, a significant proportion of capital is idle or inefficiently used.

Sometimes the services of the promoters are valued at an unduly high price. “Whenever the aggregate of the par value of stock and bonds outstanding exceeds the true value of fixed assets, the corporation is said be over-capitalised.” Practically, this accounts for a large portion of the profit and, as such, leaves a very insufficient part for the distribution of dividend for the shareholders. In other words, over­-capitalisation appears when the value of stocks and shares exceeds the current value of assets.

An over-capitalised concern either misutilises or under utilises its resources. Hence, the scarce resources of society are not properly utilised. Procurement of funds at high rate of interest will adversely affect the company resulting in over-capitalisation. Incurring high promotional expenses, excessive preliminary expenses etc. may lead to over-capitalisation.

Rigorous Taxation Policy

This strategic move involves repurchasing its own, effectively reducing the number of outstanding shares. (iii) The par value and/or number of equity shares may be reduced. (i) The profits of an over-capitalised company would show a declining trend. Such a company may resort to tactics like increase in product price or lowering of product quality. Inefficient management and extravagant organisation may also lead to over-capitalisation of the company.

If the return on equity is persistently low, it results in a decline in investor trust. We can illustrate over-capitalisation with the help of an example. With the expected earnings of 15%, the capitalisation of the company should be Rs. 20 lakhs. But if the actual capitalisation of the company is Rs. 30 lakhs, it will be over-capitalised to the extent of Rs. 10 lakhs. The actual rate of return in this case will go down to 10%. Since the rate of interest on debentures is fixed, the equity shareholders will get lower dividend in the long-run.