Capitalisation

•Capital plays an important role in any business.
•Capitalisation refers to the long term indebtedness
and includes both the ownership capital and the
borrowed capital.
•Capital and Capitalisation are two different terms.
•The term 'capitalisation' is used only in relation to
companies and not in respect of partnership firms or
sole proprietorships.
• It is distinguished from capital which represents
total investment or resources of a company.
•It thus represents total wealth of the company.

Capitalization
 It should be distinguished from share capital which
refers only to the paid up value of the shares issued by
the company and definitely excludes bonds,
debentures, loans and other form of borrowings.
 Capitalization means the total par value of all the
securities, i.e. shares and debentures issued by a
company and reserves, surplus and value of all other
long term obligations.
 The term thus includes the value of ordinary and
preference shares, the value of all surplus – earned and
capital, the value of bonds and securities still not
redeemed and the value of long term loans.
 Capitalization is thus the sum total of all long term
funds available to the firm along with the free reserves.

Definition of Capitalization
 According to E.T. Lincoln capitalization is "a word
ordinarily used to refer to the sum of outstanding
stocks and funded obligations which may represent
fictitious values".
 According to Gerstenbug, “capitalisation is that which
"comprises of a company's ownership capital which
includes capital stock and surplus in whatever form it
may appear and borrowed capital which consists of
bonds or similar evidences of long-term debt".

Overcapitalization
A company is said to be overcapitalized, when its
total capital (both equity and debt) exceeds the
true value of its assets. It is wrong to identify
overcapitalization with exess of capital because
most of the overcapitalized firms suffer from the
problems of liquidity.

Causes of overcapitalization
1. Decline in the earnings of the company.
2. Fall in dividend rates.
3. Market value of company’s share falls, and company
loses investors confidence.
4. Company may collapse at any time because of
anemic financial conditions – it will affect its
employees, society, consumers and its shareholders.

Remedies for overcapitalization
 Restructuring the firm is to be executed avoid the situation
of company becoming sick.
It involves
1. Reduction of debt burden
2. Negotiation with term lending institutions for reduction
in interest obligation.
3. Redemption of preference share through a scheme of
capital reduction.
4. Reducing the face value and paid-up value of equity
shares.
5. Initiating merger with well managed profit making
companies interested in talking over ailing company

Undercapitalization
 Under-capitalization is just the reverse of over-
capitalization. A company is considered to be under-
capitalized when its actual capitalization is lower than
its proper capitalization as warranted by its earning
capacity.

Causes of undercapitalization
 1. Under estimation of future earnings of the time of promotion
of the company.
2. Abnormal increase in earnings from new economic and
business environment.
3. Under estimation of total funds requirements.
4. Maintaining very high efficiency through improved means of
production of goods or rendering of services.
5. Companies which are set up during recession start making
higher earning capacity as soon as the recession is over.
6. Use of low capitalized rate.
7. Companies which follow conservative dividend policy will
achieve a process of gradually rising profits.
8. Purchase of assets at exceptionally low prices during recession.

Remedies of undercapitalization
 1. Splitting up at the shares – This will reduce the
dividend per share
2. Issue of bonus share: this will reduce both the
dividend per share and earning per share.
3. Both over-capitalization and under – capitalization
are detrimental to the interests of the society.

Overcapitalization
A company is said to be over capitalised when its
earnings are not sufficient to yield a fair return on
the amount of shares or debentures.
In other words, when a company is not in a position
to pay dividends and interests on its shares and
debentures at fair rates, it is said to be over
capitalised.
It means that an over-capitalised company is unable
to pay a fair return on its investment.

Definition of Overcapitalization
 According to Hoagland, "whenever the aggregate of the par
values of stocks or bonds outstanding exceeded the true
value of the fixed assets the corporation is said to be over-
capitalised".
 According to Gerstenberg, "a corporation is over-
capitalised when its earnings are not large enough to yield
a fair return on the amount of stocks and not large enough
to yield a fair return on the amount of stocks and bonds
that have been issued or when the amount of securities
outstanding exceeds the current value of assets".

Meaning of Overcapitalization
 Over-capitalisation is not synonymous with excess
capital.
 Excess of capital may be one of the reasons for over-
capitalisation.
 A company is over capitalised only because of its
capital and funds not being effectively and profitably
deployed with the result that there is a fall in the
earning capacity of the company and in the rate of
dividend to be paid to its shareholders as well as a fall
in the market value of its shares.

Causes of Over-capitalisation
 Floating of excess capital.
 Purchasing property at an inflated price.
 Inflationary conditions.
 High cost of promotion.
 Borrowings at a higher than normal rate.
 Purchase of assets in the boom period.
 Incorrect capitalization rate applied.
 Insufficient provision for depreciation.
 High rates of taxation.
 Liberal dividend policy.
 Wrong estimation of future earnings.
 Low production.

Remedial measures to correct Over-
capitalisation
 Reduction of funded debts.
 Reduction of interest on debentures and loans.
 Reduction of preference shares.
 Reduction of face value of the shares.
 Reduction in the number of equity shares.
Ploughing back of profits.

Effects of Over-capitalisation
 Effects of Over-capitalization
 Loss of goodwill.
 Difficulty in obtaining capital.
 Window dressing of accounts.
 Decline in efficiency.
 Liquidation.
 Loss of Market.
 Low rate of dividend.
 Fall in the Market value of shares
 Loss on re-organization.
 Small value of collateral.
 Speculative gambling.
 Reduction in quality.
Cuts in wages.
 Competition.
 Misapplication of society's resources.
 Gambling in shares.
 Setback to industry.

UNDER CAPITALISATION
 Under-capitalisation is just reverse of over-capitalisation.
 The state of under-capitalisation is where the value of
assets are much more than it appears in the books of the
company.
 In well established companies, there is a large appreciation
in assets, but such appreciation is now shown in the books.
 As against over-capitalisation, under-capitalisation is
associated with an effective utilisation of investments, an
exceptionally high rate of dividend and enhanced prices of
shares.
 In other words, the capital of the company is less in
proportion to its total requirements under the state of
under-capitalisation.

Definition of Undercapitalization
 In the words of Gerstenberg, "A corporation may be
under-capitalised when the rate of profits it is making
on the total capital is exceptionally high in relation to
the return enjoyed by similarly situated companies in
the same industry or when it has too little capital with
which to conduct its business".

Meaning of Undercapitalization
 Under-capitalisation is a condition where the real value of the company
is more than its book value.
 The assets bring profits but it would appear to be much larger than
warranted by book figures of the capital.
 In such cases, the dividend will naturally be high and the market value
of shares will be much higher.
 Under-capitalisation and inadequacy of capital are regarded as inter-
changeable terms but there is a difference between these two terms.
 Under-capitalisation does not mean inadequacy of capital. Profits are
high in such companies and a part of the profits are ploughed back in
the business directly or indirectly.
 The value of assets are shown at lower price than their real value. It
means that there are secret reserves in under-capitalised companies.

Causes of Under-capitalisation
 Under estimation of capital requirements.
 Under estimation of future earnings.
 Promotion during deflation.
 Narrow dividend policy.
 Desire of control.
 Excessive depreciation provided.
 Maintenance of high efficiency.
 Secret reserves.
 Difficulty in procurement of capital.

Remedies of under-capitalisation
 Splitting up of shares.
 Increasing the number of shares.
 Increase in the par value of shares.
 Issue of Bonus shares.
 Fresh issue of shares.

Effects of Under-capitalisation.
 Limited marketability of shares.
 Cut-throat competition.
 Industrial unrest.
 Dissatisfaction of customers.
 Government control.
 Inadequacy of capital.
 Secret reserves and window dressing of accounts.
 High taxes.
 Manipulation of share values.

The capital structure of a company
should be fair, neither overcapitalized,
nor undercapitalized. The availability
of funds should be neither too much
nor too low.

 A company is said to be over-capitalized when its
earnings are not sufficient to justify a fair return on the
amount of capital raised through equity and
debentures.
 It is said to be over capitalized when the total of owned
and borrowed capital exceeds its fixed and current
assets. This happens when it shows accumulated losses
on the assets side of the balance sheet.
 An over capitalized company is like a bulky person
who is not able to carry his weight properly. Such a
person is prone to many diseases and is definitely not
likely to be requisite active life. Unless the condition of
overcapitalization is rectified, the company may suffer
from many difficulties.

Causes of Over Capitalization:
 1. Idle funds:
 The company may have unused funds lying idle in banks or in the form of low
yield investments, and there is no likelihood of using it properly in the near
future.
 2. Over-valuation of acquired assets:
 The fixed assets, particularly goodwill, might have been bought at a much
higher cost than warranted by the services to be rendered.
 3. Fall in value of fixed assets:
 Fixed assets might have been acquired at a time when prices were high and now
the prices have corrected substantially. But in the balance sheet the assets are
yet shown at their book value less depreciation written off.
 4. Inadequate depreciation provision:
 If proper and adequate depreciation has not been provided on the fixed assets
the result would be more profits in the Profit & Loss Account. This book profit
might have been distributed as dividend and leaving no funds with which to
replace the assets at the right time.

Remedies of over-capitalization:
 The process of remedying overcapitalization is very painful.
It can be remedied through following measures:
 1. Reduction in its capital so as to obtain a satisfactory
relationship between proprietary funds and net profit.
 2. If over-capitalization is because of result of over-
valuation of assets then it can be remedied by bringing
down the values of assets to their proper values.
 3. Reduction of debt burden. For which negotiations with
the big lenders may be made to reduce the interest
obligation.
 4. Preference shares may be redeemed through capital
reduction scheme.
 5. Reducing face value and paid up value of equity shares.
 6. Initiating merger with well managed profit making
companies interested in taking over ailing company.
 Many Indian companies have resorted to remedying
overcapitalization through the measures mentioned above.

Under- Capitalization: If the owned capital of the firm is disproportionate to the
size of business operations and the firm has to depend
upon borrowed money and trade creditors it is a sufficient
indicator of undercapitalization. It may also be because of
over-trading, trading beyond capacity. It must be noted
that undercapitalization is different from high capital
gearing.
 In capital gearing there is a comparison between equity
capital and fixed interest bearing capital (which includes
preference share capital and excludes trade creditors)
whereas in the case of under capitalization, comparison is
made between total owned capital (both equity and
preference share capital) and total borrowed capital (which
includes trade creditors as well). Under capitalization is
signaled by low proprietary ratio, high current ratio, and
high return on equity capital.

 1. Under-estimation of future earnings in the beginning
and also later stages of the company.
 2. Extraordinary increase in earnings.
 3. Lower estimation of total fund requirements.
 4. Being highly efficient through improved technology.
 5. Companies established during recession make higher
earnings as and when the recession is over.
 6. Companies following conservative dividend policy will
in due course find themselves gradually rising profits.
 7. Purchase of assets at exceptionally low prices.

How does Undercapitalization
affect?
Undercapitalization affects different stakeholders in the different ways:
 Firm:
 Undercapitalization brings in greater reputation, greater earnings and greater
market share. Higher rate of return leads to higher competition in the market.
Higher profit means better products to follow. There would be excessive
interest on borrowed capital. However, the employees would demand higher
salaries, and the government may impose heavy tax.
 Shareholders:
 Due to increase in market share and profitability, the company enjoys better
reputation. The company's equity shares valuation goes up in the stock market.
The shareholders can expect better dividends.
 Consumers:
 Consumers often feel that they are being overcharged, and thus feel being on
the receiving end.
 Society:
 High earnings, high profitability, and high market valuation of shares affects
society in an adverse manner. Public feels being overcharged on the one hand,
and expects such firms to raise innovations, on the other. In the stock market
for such firms often unhealthy things get into currency.

Remedies of undercapitalization
 1. To reduce the dividend per share split up at the shares;
Many Indian companies, including Luxmi Machine
Works, have done it.
 2. Issue of bonus share will reduce both the dividend per
share and earnings per share.

Undercapitalization and Overcapitalization - Both
are bad!
 The conclusion is that neither undercapitalization, nor
overcapitalization is desirable, as both are evils. However, if one has to
choose between the two, undercapitalization would be the right choice:
 (a) Overcapitalization leads to the conclusion that capital is
ineffectively used and the earnings are less than being fare.
 (b) Undercapitalization, whereas, means that the rate of profit on
capital invested is higher than the normal return (enjoyed by similar
companies in the same industry or when the value of assets is more
than the amount of capital).
 (c) Undercapitalization has its own evil consequences but it is not as
fatal as in the case of over capitalization. Undercapitalization cannot
continue indefinitely because more profitability means more
competition, more government intervention, and the environment
pulls and pressures.
 (d) Overcapitalization being a serious problem, later or sooner the
company will have to be reorganized and the consequences of the same
will have to be borne by the shareholders and creditors.

CAPITALICATION
The total amount of funds available to an
undertaking should be neither too much nor too
low.
An important question, therefore is the question of
capitalization of the company, i.e., the
determination of the amount which the company
should have at least its disposal.
The total amount of long term funds available to
the company, therefore, is the capitalization of the
company.

Over-Capitalization:
 Definition and Explanation of Over Capitalization:
A concern is said to be over-capitalized if its earnings are not
sufficient to justify a fair return on the amount of share capital and
debentures that have been issued. It is said to beover capitalized when
total of owned and borrowed capital exceeds its fixed and current
assets i.e. when it shows accumulated losses on the assets side of the
balance sheet.
 An over capitalized company can be like a very fat person who cannot
carry his weight properly. Such a person is prone to many diseases and
is certainly not likely to be sufficiently active. Unless the condition of
overcapitalization is corrected, the company may find itself in great
difficulties.

Causes of Over Capitalization:
Some of the important reasons of over-capitalization are:
 Idle funds: The company may have such an amount of funds that it cannot use them
properly. Money may be living idle in banks or in the form of low yield investments.
 Over-valuation: The fixed assets, especially good will, may have been acquired at a cost
much higher than that warranted by the services which that asset could render.
 Fall in value: Fixed assets may have been acquired at a time when prices were high. with
the passage of time prices may have been fallen so that the real value of the asset may also
have come down substantially even though in the balance sheet the assets are being
being shown at book value less depreciation written off. Then the book values will be
much more than the economic value.
 Inadequate depreciation provision: Adequate provision may not have been provided on
the fixed assets with the result the profits shown by books may have been distributed as
dividend, leaving no funds with which to replace the assets at the proper time.

Remedies of Overcapitalization
 Over-capitalization can be remedied by reducing its
capital so as to obtain a satisfactory relationship
between proprietors funds and net profit. In case over-
capitalization is the result of over-valuation of assets
then it can be remedied by bringing down the values
of assets to their proper values.

Under-Capitalization:
 Definition and Explanation of Under Capitalization:
If the owned capital of the business is much less than the total borrowed
capital than it is a sign of under capitalization. This means that the owned
capital of the company is disproportionate to the scale of its operation and the
business is dependent upon borrowed money and trade creditors. Under-
capitalization may be the result of over-trading. It must be distinguished from
high gearing. Incase of capital gearing there is a comparison between equity
capital and fixed interest bearing capital (which includes reference share
capital also and excludes trade creditors) whereas in the case of under
capitalization, comparison is made between total owned capital (both equity
and preference share capital) and total borrowed capital (which includes trade
creditors also).

Under capitalization is indicated
by:
 Low proprietary Ratio
 Current Ratio
 High Return on Equity Capital

The effects of under capitalization
may be:
 Payment of excessive interest on borrowed capital.
 Use of old and out of date equipment because of
inability to purchase new plant etc.
 High cost of production because of the use of old
machinery

Distinction between Overcapitalization and
Undercapitalization
 Overcapitalization is a state where earnings are not sufficient to
justify the fair return on the amount of share capital which has
been issued by the company whereas undercapitalization is a
state where the capital which is owned by the business is much
less than the borrowed capital.
- Overcapitalization happens when the actual profits of a
company are not enough or sufficient to pay interest to the
creditors whereas undercapitalization happens due to over-
trading and when the company earn high profits as compared to
other industry.
- Overcapitalization shows the rate of return as declining entity
whereas undercapitalization shows the rate of return as
increasing entity.

Capitalisation

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