Concept of Capitalization in Financial Management

Meaning of Capitalization

Capitalization is an important constituent of financial plan. ln common parlance, the phrase ‘Capitalization’ refers to total amount of capital employed in a business. However, scholars are not unanimous in so far as capitalization  is concerned. The term capitalization connotes the process of determining the quantum of funds that a firm would require to run its business. Capitalization is distinct from share capital which refer only to the paid-up value of shares issued and definitely excludes bonds and other forms of borrowings. Similarly, it should be distinguished form ‘capital’. The term capital refers to the total investment of a company in money, tangible assets like goodwill. It is in a way the total wealth of a company. When used in the sense of net capital, it indicates the excess of total assets over liabilities. Here, then, it includes “the gains or profits from the use and investment of the capital that has not been distributed to the stockholders” and excludes losses that have resulted from the use of capital. Capitalization, on the other hand, refers only to the par value (i.e., face value indicated on the security itself) of the long-term securities (shares and debentures) plus by any reserves which are meant to be used for meting long-term and permanent needs of a company. Thus capital includes all the loans and reserves of the concern but Capitalization includes only long-term loans and retained profits besides the capital.

Narrow Interpretation of Capitalization

In its narrow sense, the term capitalization is used only in its quantitative aspect and refers to the amount at which a company’s business can be valued.

Most of the traditional authors define the term in this sense. Since this interpretation of the term is more specific though restricted, it is in this sense that the term is used here. The decision about the form of capitalization, i.e., the type of securities to be issued and the relative proportion of each type is discussed under ‘Capital Gearing’. Here, we will concentrate mainly on the amount of capitalization.

Various authors have attempted definition of the term capitalisation. The essence of all that they have stated on the subject is that capitalisation is the sum-total of all long-term securities issued by a company and the surpluses not meant for distribution. Capitalization may be said to be composed of (1) the value of shares of different kinds, (2) the value of surpluses, whether capital surpluses or earned surpluses, and (3) the value of bonds and debentures issued by a company still not redeemed. It may be added for clarification that earned surpluses represent the surplus profits accumulated over a period of time and capital surpluses are those arising from other sources. If, for example, the company sets apart a part of its profits with a view to using such reserves for meeting its long-term financial requirements, such surpluses will be called earned surpluses. On the other hand, if an asset of the company is sold at a profit, the surplus resulting from the deal will be a capital surplus. From the financial angle, such surplus is also meant for long-term use in the concern.

Broad Interpretation of Capitalization

There is a growing number of authors who regard capitalization as synonymous with financial planning.

The financial plan of company incorporates decisions about the amount of capital to be raised, the securities by the issued of which it is to be raised, and the relative proportions of the various classes of securities to be issued, as also the administration of the capital. Used in a broad sense, therefore, capitalization refers to the process of determining the plan or patterns of financing. It includes not merely the determination of the quantity (amount) of finance required for a company but also the decision about the quality of financing (which type of security is to be issued and to what extent).

Read More:

  1. What is Over Capitalization?
  2. What is Under Capitalization?
  3. Theories of Capitalization

Bases of Capitalization

One of problems facing the financial manager is determination of value at which a firm should be capitalized because it have to raise funds accordingly there are two theories that contain guidelines with which the amount of capitalization can be summarized;

1. Cost Theory of Capitalization

According to this theory capitalization of a firm is regarded as the sun of cost actually incurred in setting of the business. A film needs funds to acquire fixed assets, to defray promotional and organizational expenses and to meet current asset requirements of the enterprise sum of the costs of the above asset gives the amount of capitalization of the firm, acquiring fixed assets and to provide with necessary working capital and to cover possible initial losses, it will capitalized under this method more emphasis is laid on current investments. They are static in nature and do not have any direct relationship with the future earning capacity. This approach givens as the value of capital only at a particular point of time which would not reflect the future changes.

2. Earning Theory of Capitalization

According to this theory, firm should be capitalized on the basis of its expected earning A firm is profit is seeking entity and hence its value is determiner according to What it earns. The probable earning are forecast and them they are capitalized at a normal representative rate of return. Capitalization of a company as per the earning theory can thus be determined with help following formula.

Capitalization = Annual Net Earnings X Capitalization Rate

Thus for the purpose of determining amount of Capitalization in an enterprise the financial manager has to fist estimate of annual net earnings of the enterprise where after he will have to determine the capitalization rate. The future earning cannot be forecast exactly and depend to a large extent on such external factors which are beyond control management.

  • Estimating Annual Earnings: In capitalization of earning only future annual net earnings is used. The task of estimating future returns is difficult one. In the case of an existing concern, future  earning can be based on the past earnings since the latter givens a partial evidence of what future earnings will be in computing these historical figures care is taken to remove non-recurring gains such as gain realized on the sale of building. Usually only the earnings attributable to operations of the enterprise are included to the future that is to be capitalized. Also income tax is deducted from the earnings figures. The earning figures is further adjusted for any other factors that would make the adjusted amount more representative of the expected future earnings. The long run prospects of the company should also be taken into consideration. These estimates are then compared with the actual figures of firms engaged in the same business. Allowance of course, must be made for differences in size, age, location, managerial experience, growth rate and the like factors in such comparison. The earnings so estimated are used for capitalization purpose.
  • Determining Capitalization Rate: Capitalization rate is investor’s expected rate of return. More specifically capitalization rate is same as to cost of capital. Capitalization rate can at best be determined by studying the rate of earnings of the similarly situated companies in the same industry and the rate at which market is capitalizing the earnings. Such a study involves as analysis of the return on stocks and bonds. Thus capitalization rate must reflect return on the invested capital that would adequately compensate the investors for the use of his funds and the risk undertakes. In actual practice, average price earnings ratio of companies engaged in a particular industrial activity is taken as capitalization rate of the company. In actual practice business enterprises rely on different sources of financing for their capital needs and share capital constitutes only a part of the total funds. Under such a situation capitalization rate arrived at on the basis of price earnings ratio will not be a representative one.