Instead of $1,000,000, Company ABC decides to use $1,200,000 as its capital. The rate of earnings in this case becomes 17%, or $200,000 ÷ $1,200,000 × 100. Due to overcapitalization, the rate of return has dropped from 20% to 17%. Capitalization is a term used in corporate finance to describe the total amount of debt and equity held by a company.
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. In summary, overcapitalization can occur due to factors such as excessive expansion programs, equity base expansion, and poor financial management.
Lower Profitability
But when the boom conditions subside and recessionary conditions set in, the real value of the company’s assets fall whereas the book value of its assets remain at a, higher level. 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. Cash flow and working capital management are essential for the success of any business. Overcapitalization can lead to compromised cash flow of a business as more of it would go to interest or dividend payments than for the retained earnings. Overcapitalization in working capital is also an indication of the underutilization of assets by a business.
Repayment of long-term debts to reduce the interest payments may help an overcapitalized firm to relieve the problem. Absence of suitable depreciation policy would make the asset-values superfluous. If the depreciation or replacement provision is not adequately made, the productive worth of the assets is diminished which will definitely depress the earnings. Lowered earnings bring about fall in share values, which represents over-capitalisation. Likewise, an over-capitalised company must cut its dead weight before it becomes deep rooted and almost impossible to get rid of.
- Similarly, the capital gearing ratio will be low and the current ratio will be high.
- Undercapitalization most commonly occurs in companies with high startup costs, too much debt, and insufficient cash flow.
- This cash can earn a nominal rate of return (RoR) and increase the company’s liquidity.
- The company might incur heavy preliminary expenses such as purchase of goodwill, patents, etc.; printing of prospectus, underwriting commission, brokerage, etc.
Creditors may have to suffer since they may have to accept a lower rate of interest, and suffer permanent loss of capital in case of liquidation. The employees and labourers suffer since they cannot receive adequate salaries and wages owing to lower profit. (iv) Management should follow a conservative policy in declaring dividend and should take all measures to cut down unnecessary expenses on administration. (iv) The company may not be able to provide better working conditions and adequate wages to the workers. (iii) There may be no certainty of income to the shareholders in the future.
Overcapitalization Examples
Contrarily, a growing business would need increased borrowings inevitably. Overcapitalization in working capital can lead to distressing working capital management for any business. Cash flow is an integral part of working capital management.
These businesses do not retain sufficient cash and issue large dividends instead. For instance, a sudden drop in the value of net assets may show an overcapitalized business. Similarly, if a company has issued a large number of new shares (more than it needed), it would result in overcapitalization. In simpler terms, it occurs when a company’s assets are overvalued compared to their actual earning potential.
Under-Utilization of Assets
Hence, it is essential for companies to manage their capital carefully and avoid overcapitalization to ensure their long-term success. If a company is floated under the conditions of inflation, it requires a large fund for acquiring its necessary assets. But when depression sets in, naturally, the prices of the assets fall which ultimately leads to over-capitalisation.
If the earnings are up to the general expectation, a concern will not be over capitalized even though a part of its capital is watered. Overcapitalization is a financial term that refers to a company that has taken on too much capital investment, resulting in an imbalance between the value of its assets and its earning capacity. Overcapitalization can result in a decline in a company’s earnings as it is unable to generate returns on the unused capital. For example, in the 1920s, the aviation industry overexpanded and faced massive overcapitalization. Many manufacturers produced more planes than could be sold, leading to a situation where unused capital could not generate returns.
- (ii) Long-term borrowings carrying higher rate of interest may be redeemed out of existing resources.
- We can illustrate over-capitalisation with the help of an example.
- According to a report by McKinsey & Company, overcapitalization was a significant contributor to the failure of several high-profile companies, including Lehman Brothers and Enron.
- If the company is not in a position to invest these funds profitably, the company will have more capital than required.
- To address overcapitalisation, companies may consider strategies such as returning excess capital to shareholders, retiring debt, or reinvesting in growth opportunities.
Overcapitalization can be corrected through a number of measures, causes of over capitalisation such as selling off excess assets, restructuring debt, and reducing expenses. However, these measures can be painful and may require significant sacrifices on the part of the company and its stakeholders. 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.
What Causes a Company to Become Overcapitalized?
Thus, if a business can keep its cashflows and working capital smooth, it can avoid the problems of capitalization. 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.
Acquiring assets at inflated prices:
Investors lose faith in the company due to irregular dividend payments brought on by a decline in earning potential. As a result, it has a tough time obtaining the necessary funding from the capital market to meet its needs for growth and development. Commercial banks are also hesitant to provide such a company with short-term advances to cover its working capital needs, which will impede output. Overcapitalised businesses occasionally risk missing deadlines for principal repayment and interest payments. In this scenario, creditors demand that the corporation be reorganised. For similar reasons, banks and other financial organisations are reluctant to provide loans.
Companies must pay high prices for fixed assets during a boom and maintain elevated capitalisation levels. Up until inflationary conditions take hold, higher capitalization is acceptable. The actual worth of the company’s assets, however, declines. In contrast, the book value of its assets stays at a greater level as the boom circumstances fade and recessionary circumstances take hold.
In this article, we learned about overcapitalisation, which is the practice of raising more money than is necessary to provide the profit level the firm is now earning. It is also not supported by the level of revenue-generating assets currently in place and the company’s future growth prospects. When such capital is generated by debt or even stock, it results in a high cost of capital burden.
This malpractice further adds to the losses of the shareholders. 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. 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.
The amount available due to reorganisation of share capital is utilised for writing off the fictitious assets and other over-valued assets. Preference shares carrying high rate of dividend should be redeemed out of retained earnings in order to raise the share of equity shareholders. Many companies prefer to declare a higher rate of dividend instead of retaining a part of the profits and ploughing them back or reinvesting them.