Overcapitalization occurs when a company has issued more in debt and equity than its assets are worth. If this is the case, the market value of the company is less than the total capitalized value of the company. An overcapitalized company might be paying more in interest and dividend payments than it can sustain in the long term.
It is the capitalization under which the actual profits of the company are not sufficient to pay interest on debentures and borrowings and a fair rate of dividend to shareholders over a period of time. In other words, a company is said to be over-capitalised when it is not able to pay interest on debentures and loans and ensure a fair return to the shareholders.
- A high amount of preliminary expenses may be a reason for overcapitalization as they are shown as assets i.e. fictitious assets in the balance sheet.
- Poor planning of initial equity requirements may result in overestimation of funds.
- Insufficient provision for depreciation consumes unnecessary profits and reduces the overall earning capacity of the company.
- A sudden change in the business environment due to a shift in the domestic, international or political environment may reduce the earnings of a company.
- Acquisition of unproductive assets or buying them at inflated prices may also result in overcapitalization of a company.
- Underutilization of funds and poor management.
Inefficient management and extravagant organisation may also lead to over-capitalisation of the company. The earnings of the company will be low.
Insufficient Provision for Depreciation:
Depreciation may be charged at a lower rate than warranted by the life and use of the assets, and the company may not make sufficient provisions for replacement of assets. This will reduce the earning capacity of the company.
Higher Promotional Expenses:
The company might incur heavy preliminary expenses such as purchase of goodwill, patents, etc.; printing of prospectus, underwriting commission, brokerage, etc. These expenses are not productive but are shown as assets.
Liberal Dividend Policy:
The company may follow a liberal dividend policy and may not retain sufficient funds for self-financing. This may lead to over-capitalisation in the long-run.
The directors of the company may over-estimate the earnings of the company and raise capital accordingly. If the company is not in a position to invest these funds profitably, the company will have more capital than is required. Consequently, the rate of earnings per shares will be less.
Acquisition of Assets at Higher Prices:
Assets might have been acquired at inflated prices or at a time when the prices were at their peak. In both the cases, the real value of the company would be below its book value and the earnings very low.
- Return on capital employed is very low. This means that financial resources of the public are not being utilised properly.
- The profits of an over-capitalised company would show a declining trend. Such a company may resort to tactics like increase in product price or lowering of product quality.
- The company may not be able to provide better working conditions and adequate wages to the workers.
- An over-capitalised company may not be able to pay interest to the creditors regularly.
Consequences of Over-capitalisation on Shareholders:
- Market value of shares will go down because of lower profitability.
- Over-capitalisation results in reduced earnings for the company. This means the shareholders will get lesser dividend.
- There may be no certainty of income to the shareholders in the future.
- In case of reorganisation, the face value of the equity share might be brought down.
- The reputation of the company will go down. Because of this, the shares of the company may not be easily marketable.
Consequences of Over-capitalisation on Company:
- The company may not be able to raise fresh capital from the market.
- The shares of the company may not be easily marketable because of reduced earnings per share.
- Reduced earnings may force the management to follow unfair practices. It may manipulate the accounts to show higher profits.
- Because of low earnings, reputation of the company would be lowered.
- Management may cut down expenditure on maintenance and replacement of assets. Proper amount of depreciation of assets may not be provided for.
- Long-term borrowings carrying higher rate of interest may be redeemed out of existing resources.
- Repayment of long-term debts to reduce the interest payments may help an overcapitalized firm to relieve the problem.
- The earning capacity of the company should be increased by raising the efficiency of human and non-human resources of the company.
- Debt restructuring with banks and other lenders to reduce the interest obligation is another possible remedy.
- Management should follow a conservative policy in declaring dividend and should take all measures to cut down unnecessary expenses on administration.
- The par value and/or number of equity shares may be reduced.
- Reduction in face value & buyback of shares.