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.
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- Use of old and out of date equipment because of inability to purchase new plant etc.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
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.
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 articles from “financial statement analysis” chapter:
- Horizontal and Vertical Analysis
- Ratios Analysis
- Horizontal Analysis or Trend Analysis
- Trend Percentage
- Vertical Analysis
- Accounting Ratios Definition, Advantages, Classification and Limitations:
- Gross profit ratio
- Net profit ratio
- Operating ratio
- Expense ratio
- Return on shareholders investment or net worth
- Return on equity capital
- Return on capital employed (ROCE) Ratio
- Dividend yield ratio
- Dividend payout ratio
- Earnings Per Share (EPS) Ratio
- Price earning ratio
- Current ratio
- Liquid/Acid test/Quick ratio
- Inventory/Stock turnover ratio
- Debtors/Receivables turnover ratio
- Average collection period
- Creditors/Payable turnover ratio
- Working capital turnover ratio
- Fixed assets turnover ratio
- Over and under trading
- Debt-to-equity ratio
- Proprietary or Equity ratio
- Ratio of fixed assets to shareholders funds
- Ratio of current assets to shareholders funds
- Interest coverage ratio
- Capital gearing ratio
- Over and under capitalization
- Financial-Accounting- Ratios Formulas
- Limitations of Financial Statement Analysis