Over-capitalization and Under-capitalization:
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.
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- Use of old and out of date equipment because of inability to purchase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
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 be over 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:
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.
You may also be interested in other relevant articles:
Profitability ratios:
Liquidity ratios:
Activity ratios:
Leverage ratios or long term
solvency ratios:
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