Contents :
- Meaning and Definition of Capitalisation.
- Meaning and Definition of Over Capitalisation.
- Causes of Over Capitalisation.
- Consequences / Disadvantages of Over Capitalisation
- Remedies of Over Capitalisation.
- Meaning and Definition of Under Capitalisation.
- Causes of Under Capitalisation.
- Consequences / Disadvantages of Under Capitalisation.
- Remedies of Under Capitalisation.
What is Capitalisation ?
Capitalisation is an important part of financial planning. In common practice, capitalization refers to the total amount of capital employed in a business. This meaning is used in a narrow sense. Broadly speaking, capitalisation refers to the act of deciding in advance the quantum of fund requirements of a firm, its patterns and administration of capital in the interest of the firm.
Meaning of Capitalisation
The term Capitalisation means total amount of long term funds available to the company. In the words of Dewing, "Capitalisation includes capital stock and debt. Therefore, capitalisation includes shares and debentures issued by the company and also the long term loans taken from the financial institutions. Capital surplus will always be a part of total capitalisation though it is available for cash, dividend under certain circumstances. Revenue surplus will be a part of capitalisation if the management wants to retain it in the business. The amount of capitalisation should be only that much which can be justified by its profits and by the normal rate of return for the industry concern. If the company earns less than the other companies in the same industry, value of shares of a company will reduce and the company will suffer.
Definitions of Capitalisation
According to Guthman and Dougall :
“Capitalisation is the sum of the par value of the stocks and bonds outstanding." According to them, capitalisation of a company comprises only share capital and funded debts and it does not include reserves and surplus.
According to Gerestenberg :
"Capitalisation is the total accounting value of all the capital regularly required in the business."
According to Walker and Baughn :
"The use of capitalisation refers to only long-term debt and capital stock only and short term creditors, do not constitute supplies of capital. In reality, total capital is funded by short-term creditors, long - term creditors and others".
From the above definitions, capitalisation can be summarized as under :
- Capitalisation is the net worth of the business which includes actual assets involves tangible as well as intangible assets.
- Capitalisation also comprises the ownership capital and borrowed capital as represented by long-term indebtedness.
- Capitalisation is total accounting value of capital stock, surplus and long-term debt.
Business Finance Related Terms :
What is Over - Capitalisation ?
Many times, over-capitalisation is understood that it is a condition of excess capital. But actually speaking, it is incorrect. Over-capitalisation does not mean an abundance of capital.
Meaning of Over - Capitalisation
Over-capitalisation is a state of affairs in which the account of issued shares is much more than the requirements of the company. Over-capitalisation reduces the rate of dividend and value of shares in a market. Over-capitalisation is a relative term used to denote that there is no reasonable earnings on its fund.
Definitions of Over - Capitalisation
According to Bonneville, Dewey and Kelly :
“When a business is unable to earn a fair rate of return on its outstanding securities, it is over capitalised."
According to Gerestenberg :
"A Corporation is over-capitalised when its earnings are not large enougn to yield a fair return on the amount of stocks and bonds that have been received". Thus, over-capitalisation means where book value of share is higner than the real value of a company. It can be treated as over-capitalised when it is not able to earn fair income over a long period of time.
Causes of Over - Capitalisation
1) Excess Issue of Capital :
Many times, the company issues more capital than actually required. The excess capital may lead to over-capitalisation. The excess issue of capital cannot be protitably employed in the business. So it is unnecessary burden on the business.
2) Borrowed Capital :
When a company borrows a large amount of money which is having a higher rate of interest then its rate of earnings will be treated as over-capitalisation. The company has to pay a large part of their earnings by way of interest and there is no more scope to pay the higher dividends to shareholders.
3) Purchase of Properties of Inflated Price :
Many times, the company purchases the assets which are created at the time of incorporation. In such situations, there is a possibility of charging inflated prices rather than real value of assets.
4) Heavy Capital Expenditure :
If the heavy expenses are incurred at the promoting stage, it may lead to over- capitalisation. The company might have spend huge amounts during its formation stage or might have spend huge amounts for the purchase of intangible assets like goodwill, patents, trade marks, etc. As a result, the earning capacity of the company may be adversely affected.
5) inadequate Provision for Depreciation :
Because of inadequate provision for depreciation, replacement or obsolescence of assets may lead to over-capitalisation. Inadequate provision causes inefficiency which results in its reduced earning capacity.
6) Liberal Dividend Policy :
Many times, a company declares higher rate of dividends to attract the shareholders. For doing so, the company manipulates the accounts so that in the long run, the real value of the shares comes down.
7) Tax Saving Policy :
In order to avoid heavy tax liability, many companies manipulate their accounts in such a way that there will be less income for dividend distribution. Ultimately, it adversely affects on company's operating efficiency and company suffers from over-capitalisation.
8) Absence of Adequate Reserves :
Many times, entire profit is distributed in the form of dividend and do not make adequate provisions for reserves. It discloses excessive profit which is treated as over-capitalisation.
9) Wrong Capitalisation Rate :
According to the theory of capitalisation, the capitalisation is the amount of earnings capitalised at a representative rate of return. As such, if capitalisation rate is wrong, the amount of capitalisation will be wrong in such a way that lower the rate of capitalisation, higher will be the amount of capitalisation.
Consequences / Disadvantages of Over - Capitalisation
The consequences of over-capitalisation can be explained from the various angles i.e. the company, society and shareholders.
A] From the Company's Point of View :
1) Reduction in Rate of Dividend :
Over-capitalisation leads to reduction in rate of dividend on equity shares because the profits are distributed over a large number of shares.
2) Falling the Market Value of Shares :
Because of the reduction in rate of dividend, it also affects the falling prices of the shares. It also looses the confidence of investors.
3) Reduction in Efficiency :
Over-capitalisation may leads to the reduction in efficiency of the company. Many times it becomes difficult to manage with the limited funds.
4) Obstruction in Expansion of Business :
Over capitalisation leads to the vicious circle of the organisation. The company faces many problems at the time of expansion of business because of over- capitalisation.
5) Closing Down of Business :
It becomes difficult to come out from the stage of over-capitalisation which ultimately leads to closing down of business.
B] From the Shareholder's Point of View :
1) Uncertainty about the Dividend :
Because of over-capitalisation', there is no certainty about the income the shareholders cannot expect the fair returns on their investment.
2) Depreciation of Investment :
Because of over capitalisation the market price of the shares comes down. So shareholders cannot get fair returns on it.
3) Increase in Speculation :
Over-capitalisation leads to an increase in speculation transactions which adversely affects on the interest of real investors.
C] From the Society's Point of View :
1) Increase in Prices of Goods :
Over-capitalisation unnecessarily increases the prices of the product and it also deteriorates the quality of products.
2) Decrease in Wages :
Over-capitalisation leads to a decrease in income of the company which ultimately affects a reduction in wages.
3) Unfair Competition :
Over-capitalisation leads to lose the confidence of the society, because it is also unable to compete with other business enterprises. Indirectly, it will affect the interest of creditors and workers.
4) Under-utilisation of Resources :
Because of over-capitalisation, many resources remain idle. It cannot be utilised 100%.
Remedies of Over - Capitalisation
In order to avoid the consequences of over-capitalisation, the following steps should be adopted by the company:
1) Reduction of Funded Debts :
As far as possible, a company should try to redeem the debts with accumulated reserves.
2) Reduction of Interest Rate :
For coming out of over-capltalisation stage, it is essential to reduce the interest rates on debentures, bonds, etc.
3) Reduction of Preferred Stock :
If possible, preferred stock should be redeemed in a order to reduce the liability of higher dividend.
4) Reduction of Par Value of Shares :
It is a good method but its shareholders should be convinced in proper way.
5) Reduction in Number of Equity Shares :
This method can also be implemented if the shareholders are ready for it. This can be done only after taking the shareholders into confidence.
What is Under - Capitalisation ?
Under-capitalisation is nothing but the reverse situation of over-capitalisation. Under capitalisation should not be considered as inadequacy of capital. Under capitalisation is an index of effective and proper utilisation of funds employed in the business.
Meaning of Under - Capitalisation
when a company is in a position to declare a high rate of dividend and the prices of the shares are increased, it is called as under capitalisation. In actual practice, if the minimum subscription is not obtained and the company runs its operations then it has to procure short term loans to avoid the under capitalisation.
Definition of Under - Capitalisation
According to Gerestenberg :
"A corporation may be under-capitalised when the rate of profit, if 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 to conduct its business."
On the above definition, it can be stated that basis of capitalisation is not a economic problem. But a problem is adjusting the capital structure or it can be a sign of sound financial position and good management of the company.
Causes of Under-Capitalisation
1) Under Estimation of Capital Requirements :
At the initial stage, at the time of promotion, if the proper estimation is not done regarding requirements of the funds, it may result in shortage of capital. If its earnings are more than the capital invested, it may be treated as under-capitalisation.
2) Depression :
During depression period, long term assets are purchased at a lower rate and the earning rate is more than the value of it. Such cases are treated as under capitalised.
3) Difficulty in Procurement of Capital :
Due to depression, many times it may become difficult to procure the necessary amount of capital. Even then a company runs its operations. such situation level is known as under capitalisation.
4) Conservative Dividend Policy :
Many organisations adopt conservative dividend policy and create sufficient reserves for depreciation, replacements and renewals of assets and plough back of profits. Such a policy leads to high earnings which increases the real values of the company's shares as compared to book value. This situation is also known as under capitalisation.
5) Maintain High Standard of Efficiency :
By employing new methods and techniques of the production, the efficiency of the organisation can be improved and profit can be increased. In such cases, the real value of shares exceeds than the book value of shares which is known as under capitalisation.
6) Control on Issue of Shares :
Many times, a company keeps control on issue of shares and manage the business in limited funds. This may lead to under-capitalisation.
Consequences / Disadvantages of Under Capitalisation
1) Limited Marketability of Shares :
Because of conservative policy and strict control over the issue of shares, there is a limited marketability to the securities of the company. Hence, the stock may not enjoy the benefits of the fluctuations in the share prices.
2) Cut-throat Competition :
It may lead to cut-throat competitions because a high rate of dividend may encourage potential competitors to enter the market.
3) Increase in Worker's Demand :
Due to a continuous increase in profitability rate, workers may demand an increase in wage rates and other benefits. If the demands are not fulfilled, they can create various problems.
4) Increase in Tax Liability :
If there is an increase in-volume of profits, it may increase the tax liability.
5) Dependence on Outside Sources :
Due to inadequacy of capital, many times a company has to borrow funds from outside sources at a higher rate of interest which may create additional obligation on the company.
6) Dissatisfaction among the Customers :
Customers are under impression that they are being overcharged and so they compel the company to reduce the prices of the goods.
7) Danger of Liquidation :
Under-capitalised organisations cannot successfully continue for long as the is always possibility for liquidation.
Remedies for Under - Capitalisation
1) Minimum Subscription Clause :
In order to avoid under-capitalisation situation, a provision is made in The Companies Act, 1956 regarding the allotment of shares. As per this Act, no allotment of the shares can be done unless the minimum subscription has been collected.
2) Splitting Up of Shares :
In order to decrease the rate of earnings per share, the directors of the company take the decision regarding splitting up of shares. It does not affect the total capitalisation but it affects on a decrease in par value of stock.
3) Issue of Bonus Shares :
If the company has adequate surplus and reserves then the company can issue bonus shares and company can capitalise such profits.
4) Capitalisation of Earning :
Retained earnings have no explicit costs. They should be capitalised and they will also be a part of cost bearing capital. It will bring down the dividend at a reasonable level.
5) Fresh Issue :
If additional funds are needed, fresh unissued shares may be issued to the public and total capital can be increased.