If a company raises more capital (by the issue of shares and debentures and through long-term loans) than is warranted by the figure of capitalisation of its earning power, the company will be said to be over-capitalized.
In other words, a company is over-capitalized when its actual profits are not sufficient to pay interest and dividends at proper rates. It follows that an over-capitalized company is unable to pay a fair return on its capital investment. Thus if a company earns Rs. 1,50,000 with the general expectation at 10 per cent, capitalisation at Rs. 15,00,000 would b proper. But if the company, somehow, issues shares and debentures to the extent of Rs. 25,00,000, the rat of earning will be only 6 per cent because with surplus but idle funds profits will still remain Rs. 1,50,000. This company is over-capitalized. However, over-capitalisation is not quite the same thing as excess of capital. A company is over-capitalized only because the existing capital is not effectively utilised with the result that there is a fall in the earning capacity, and consequently in the rate of dividend payable to equity shareholders. This usually leads to a decline in the market value of the shares. The chief sign of over-capitalizations is, therefore, a fall in the rate of dividend over a long-term period. This means that over-capitalisation presents a chronic conditions and is not based on the results of only a few years. To emphasize this point, it may be stated that “when a company has consistently (regularly) been unable to earn the prevailing rate of return on its outstanding securities (considering the earnings of similar companies in the same industry and the degree of risk involved) it is said to be over-capitalized”. Over capitalisation results in the following ways:
(1) The enterprise may raise more money by issue of shares and debentures than it can profitably use. In other words, there may be large amounts of idle funds with the company. This may be done intentionally or unintentionally. Some companies, for instance, are tempted by a favourable sentiment in the market, and issue too large a number of shares.
(2) If a company borrows a large sum of money and has to pay a rate of interest higher than its rate of earning, the results will be over-capitalisation. A major part of the earnings may be given away to the creditors as interest,leaving little for the shareholders. The rate of dividend is thus lowered and the market value of the shares also declines.
(3) Over-capitalisation may often result when an excessive amount is paid for goodwill and for fixed assets acquired from the vendor company or from promoters or other people associated with the company, or when unduly high amounts are spent on establishment. In such cases, the price paid for the requisition of a going concern has no relation to its earning capacity.
(4) Sometimes a company acquires assets like plant, machinery and buildings during a boom period. The price paid is naturally high. If the boom disappears and a slump sets in, the real value of such assets will greatly decline and a large part of the company’s capital would be lost even though the books will still show the assets an the capital at their previous figures. Such a company is over-capitalized because its real earnings capacity will suffer a setback due to a fall in the value of assets, whereas the capital will stand at its original figures.
(5) If a company does not make sufficient provision for depreciation and replacement and distributes higher rates of profit amongst the shareholders, the company will find after some time that, while the book value of assets is high, the real, value is extremely low. The efficiency of the company is adversely affected and its earnings go down thus bringing down the market value of the shares. This is yet another case of over-capitalisation.
(6) High rates of taxation may leave little in the hands of the company to provide for depreciation and replacement and dividend to shareholders. This may adversely affect its earnings capacity and lead to over-capitalisation.
(7) When the promoters underestimate the capitalisation rate, the capitalisation may not support the expected rate of earnings and over-capitalisation may result.
‘Water’ is said to be present in the capital when a part of the capital is not represented by assets. It is considered to be as worthless as water. Sometimes the services of the promoters are valued at an unduly high price.
Similarly, the concern may pay too high a price for an asset acquired from a going concern. The capital becomes watered to the extent of the excess price paid for an asset. Thus, if a company pays 1,25,000 on account of goodwill, which if valued correctly is worth Rs. 50,000 only, the capital is watered to the extent of Rs. 75,000. ‘Watered capital’ must be distinguished from ‘over capitalisation’. ‘Water enters the capital usually in the initial period-at the time of promotion. Over capitalisation can, however, be found out only after the company has worked for some time. Although watered capital can be a cause of over-capitalisation, yet it is not exactly the same thing. If the earnings are up to the general expectation, a concern will not be over capitalized even though a part of its capital is watered.