Impact of Overcapitalisation and What Can You Do to Solve It

Companies that emphasise high profitability will carry shorter lines consisting of carefully chosen items. “A certain degree of over­capitalisation ,”says Beacham, “may be caused by heavy issue expenses”. If expenses incurred for promotion, issue and underwriting of shares, promoters’ remuneration etc., prove to be higher compared to the benefits they provide, the enterprise will find itself over-capitalised. 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.

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 causes of over capitalisation will decline, and the value of its shares will diminish. Overcapitalization can have negative effects on a company’s capital structure and shareholder value. It is important for companies to carefully manage their capital structure and avoid investing in assets or projects that do not provide sufficient returns. By doing so, companies can maintain a strong balance sheet, generate positive returns for investors, and avoid the negative effects of overcapitalization. For instance, some analysts have argued that tech giant Apple is overcapitalized, with a cash pile of over $200 billion.

Causes and Effects of Overcapitalization

Explore options like equity investment, bank loans, venture capital, crowdfunding, or government grants to create a more balanced capital structure. Without adequate capital, companies miss out on opportunities such as expanding to new markets, investing in R&D, or upgrading equipment. Undercapitalization can have far-reaching consequences, affecting both day-to-day operations and long-term growth. (iii) The par value and/or number of equity shares may be reduced.

The company’s stock price plummeted due to its massive debt burden from this overcapitalized project. While BP eventually recovered financially, it took years and significant restructuring efforts to regain its footing in the market. Another essential aspect to consider is how these financial states impact companies and investors.

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When a company finds itself in this situation, it may have excess capital or cash on its balance sheet. This cash can earn a nominal rate of return (RoR) and increase the company’s liquidity. Common causes of overcapitalization are poor management and high startup costs. If a business becomes overcapitalized, its options for recovery are limited; management would need to find a way to restructure its debts or explore opportunities for merger with another business. Another effective method of correcting under-capitalisation is to split up the existing stock into larger number of shares reducing the value of each share.

Originally, it was used in the sense of ‘valuation’ and ‘amount’ but qualitative connotation now usually accompanies the quantitative expression. The term capitalisation is now taken as being synonymous with capital structure or financial plan. We hope you found this article informative and gained valuable insights into this important financial concept. The consequences of overcapitalization for XYZ Enterprises can include financial distress, reduced profitability, and even the potential for bankruptcy if the situation is not addressed effectively.

• You can easily calculate this figure by multiplying the price of one share by the total number of shares outstanding.
• The acquisition proved unprofitable as the combined company struggled to generate sufficient cash flow to service this increased debt load.
• The company now finds itself with excess production capacity, high debt obligations, and limited cash flow.
• Undercapitalization occurs when a business lacks sufficient funds to cover its operational needs or pursue growth opportunities.
• These buybacks are part of Infosys’ broader capital management strategy to strike a balance between financial stability and shareholder value creation.

Both over-capitalization and under-capitalization represent extremes in a company’s capital structure that can negatively impact its operations, profitability, and long-term sustainability. Achieving a balanced and appropriate level of capital is essential for any business to operate efficiently and grow sustainably. Proper financial planning, forecasting, and capital management are key to avoiding these two extremes and ensuring long-term financial health. If a company has small share capital it will be forced to raise loans at heavy rate of interest. This would reduce the net earnings available for dividends to shareholders. Lower earnings bring down the value of shares leading to over-capitalisation.

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Heavy borrowing, excessive spending on non-essential assets, and unrealistic assessment of market demand are common causes of overcapitalization. Let’s explore an example to better illustrate the concept of overcapitalization. Imagine a company, XYZ Enterprises, that operates in the manufacturing industry.

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Regulators play an important role in insurance markets where overcapitalization is prevalent. They closely monitor these situations to ensure that consumers are protected from excessive competition and price erosion. Regulations may include restrictions on new policy issuance or mergers and acquisitions to help stabilize the market and maintain profitability for insurers. Shweta Desai is a personal finance enthusiast dedicated to helping readers make sense of money matters.

The remedial procedure of over-capitalisation is more difficult and expensive as compared to the remedial procedure of under-capitalisation. The failure of such over-capitalized concerns tends to precipitate panic. Industrial development languishes, and labourers lose employment. Owing to fall in purchasing power of the labour class their demand tends to decline.

It neither affects the total earnings of the company nor the total amount of capital of the company but still dividend per share shall reduce. The company may issue bonus shares by capitalising its accumulated earnings. This is the most commonly used and effective method of correcting under-capitalisation. If under-capitalisation is due to inadequacy of capital, then it can be corrected by the issue of fresh shares, the company may also redeem its long-term debt by the issue of fresh share capital.

Under-capitalisation eventually leads to over-capitalisation because of excessive profits, huge retained earnings and long-term debt financing. 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. The term under-capitalisation should never be considered synonymous with inadequate capital. Businesses can avoid undercapitalization through effective financial planning, cash flow management, cost optimization, and by maintaining a diversified funding base.

• While Apple has used some of this cash to repurchase shares, some investors argue that the company should do more to return capital to shareholders or invest in new growth opportunities.
• Market capitalization refers to the total dollar value of a company’s outstanding shares.
• 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 not uncommon to find that many concerns are over-capitalised due to insufficient provision for depreciation/replacement or obsolescence of assets.

It can result from factors like overvalued assets, excessive borrowing, or overly optimistic growth expectations. Acquisition of unproductive assets or buying them at inflated prices may also result in the overcapitalization of a company. High rates of taxation may leave little in the hands of the company to provide for depreciation and replacement and dividends to shareholders. This may adversely affect its earning capacity and lead to over-capitalisation. Certain companies do not believe in making adequate provision for various types of reserves and distribute the entire profit in the form of dividends. Such a policy reduces the real profit of the company and the book value of the shares lags much behind its real value.

Under-Capitalisation: Causes, Effects and Remedies

Under-capitalization is the reverse, where a company earns extraordinarily high returns over its capital. Causes of over-capitalization include excessive purchase of fixed assets and liberal dividend policies. Causes of under-capitalization include high efficiency and conservative dividend policies.

A business is said to be overcapitalised if the value of its debt and stock exceeds the value of its whole assets. Accordingly, its market value is lower than its capitalised value. Overcapitalisation has many negatives, including poor credit worthiness, reduced dividend rate, loss to shareholders and creditors, and recession. This problem typically occurs when a business raises more money than its actual earnings can support. It should be noted that overcapitalisation does not always imply an excess of capital.

In summary, overcapitalization can have significant effects on shareholder value. By understanding the causes and consequences of overcapitalization, investors can make better-informed decisions about the companies they choose to invest in. For example, a company may have generated significant cash flow from its operations but has not found the right investment opportunities to put the cash to work. Alternatively, a company may have taken on too much debt to fund growth initiatives, leaving it overleveraged. The consequences of WorldCom’s overcapitalization were devastating, with the company facing a massive accounting scandal and subsequent bankruptcy proceedings. However, this unfortunate event serves as a reminder for investors that excessive capital expenditures and acquisitions can lead to an unsustainable financial situation.

This happens because the company is not using its funds in the most effective way, which results in lower returns. Additionally, this can lead to the company having too many assets, which it is not utilizing efficiently. Understanding overcapitalization is crucial for institutional investors as it can significantly impact a company’s financial health and potential investment opportunities.