Over-Capitalization: Concept, Causes, and Remedies¶
Concept of Over-Capitalization:
Over-Capitalization can be defined as the state of financial affairs in a company where the real value of the company's assets is significantly less than their book value, leading to a permanent decline in the earning capacity of the company. In simpler terms, it occurs when a company's assets are overvalued compared to their actual earning potential.
Illustration:
For example, if a company's book value of assets is Rs. 25,00,000 (represented by a capitalization of 25,00,000, consisting of equity capital, preference capital, and debentures), but the real value of assets based on their earning capacity is only Rs. 15,00,000, there is over-capitalization in the company to the extent of Rs. 10,00,000. This means that the company's earnings are generated only from Rs. 15,00,000 worth of assets, while it has a capitalization of Rs. 25,00,000. The excess capital, in this case, represents idle funds that do not produce any benefits or profits for the company.
Causes of Over-Capitalization:
Several factors can lead to over-capitalization in a company:
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Assets Acquired at Inflated Prices: When assets are acquired at prices significantly higher than their actual value, it results in over-capitalization. This occurs when promoters or management pay an excess price for assets that does not align with their earning capacity.
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Issue of Excessive Finances: Sometimes, during a favorable market sentiment, promoters may issue excessive shares or securities, leading to the infusion of more capital than the company can profitably use. This excess capital becomes non-earning and contributes to over-capitalization.
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Huge Borrowings at High Interest Rates: If a company borrows a substantial amount of money through debentures or loans at high-interest rates, a significant portion of its earnings may go towards interest payments, leaving little surplus for equity shareholders. This can result in over-capitalization.
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Liberal Dividend Policy: When a company follows a liberal dividend policy, distributing a large portion of its earnings as dividends, it may not have enough profits left for reinvestment in the business. This can hinder growth and lead to over-capitalization.
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High Corporate Taxes: High corporate taxes can reduce the profits available for reinvestment and paying returns to equity shareholders. This can contribute to the problem of over-capitalization.
Consequences of Over-Capitalization:
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Consequences for the Company:
- Reduced market value of the company's shares.
- Loss of goodwill and investors' confidence.
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Consequences for the Members (Shareholders):
- Reduced and uncertain dividends.
- Capital loss due to poor market value of shares.
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Consequences for the Workers (Employees):
- Possible wage cuts due to reduced profitability.
- Risk of job loss if the company faces liquidation.
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Consequences for the Society:
- Wastage of economic resources.
- Economic impact due to loss of production and employment opportunities.
Remedies for Over-Capitalization:
Several measures can be taken to address the issue of over-capitalization: - Reducing Capital: The company can reduce its capital through methods like buybacks or cancellation of excessive shares. - Increasing Earnings: Focusing on improving the company's profitability and earning capacity. - Optimizing Capital Structure: Properly structuring the company's capital by balancing equity and debt. - Dividend Policy: Revising the dividend policy to retain more earnings for reinvestment. - Asset Revaluation: Revaluing the assets to reflect their true earning potential. - Efficient Cost Management: Managing costs effectively to enhance profitability.
Over-capitalization is a financial condition that can have significant negative consequences for a company and its stakeholders. Identifying the causes and implementing appropriate remedies is essential to restore the company's financial health and competitiveness.
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