What is Over Capitalization?

Concept of Over Capitalization

The phrase ‘Over Capitalization’ should not be confused with excess of capital. Truly speaking, over capitalization is a relative term used to denote that the firm in question is not earning reasonable income on its funds.

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 capitalized. Thus over capitalization refers to that state of affairs where earning of the corporation do not justify the amount of capital invested in the business. The main symptom of over capitalization in a company is the amount of earning which it is making on its total capital. Thus, a company is said to be over capitalized when it earns less than what it should have earned as fair rate of return on its total capital. To ascertain whether the company is earning reasonable rate of return, a comparison of the company’s rate of earnings should be made with earning rates of return, it is indicative of the fact that the company is not able to earn fair rate of return on its capital. However, this is not logical. In the first instance, par value-face value of shares is static in character, which remains unaffected by business oscillation. Secondly, market value of shares of a company is highly volatile. It is a state of affair in which dividend rate is too low to sell shares at their par value. It denotes low earning for share and high proprietary ratio. Similarly, the capital gearing ratio will be low and the current ratio will be high. It depends mainly upon internal factors like present and perspective earnings position of enterprise and its dividend policy and external factors such as general price level changes, purchasing power and economic and industry policy of government. In view of this, market value of shares of a company can at best be worked out by averaging out the market price of shares of the company ruling in the market over different dates. Thus, comparison of book value with real value of share is the most satisfactory criterion to test the state over capitalization.

Cause of Over Capitalization

There are various factors responsible for over capitalized state of a company important among these are listed below:

  1. Promotion of a company with inflated assets: A company right from its incorporation falls prey to over capitalization. if it has been established with assets acquired at higher prices which do not bear any relation to their earning capacity. This situation arises generally when partnership firm or private limited company is transferred to public limited company because in this case assets may be transferred at a price higher than its real value. So book value- would be higher than real value.
  2. Over estimation of earnings at the time of promotion: A mistake in initial estimation of earning may land a company in the sate of over capitalization since capitalization based on such an estimate is not justified by income which the company actually earns.
  3. Application of high capitalization rate: Despite correct estimate of earnings a company may be in a State of over capitalization if higher capitalization rate was applied to determine its total capitalization.
  4. Formation of company during inflationary period: Generally company started in inflationary conditions turns into over capitalization after the inflationary conditions subside. This happens because assets which were acquired at inflated prices do not bear any relation to their earning capacity.
  5. Defective depreciation policy: Many companies become over capitalized because they do not make adequate provision for depreciation, replacement or obsolescence of assets. This causes inefficiency in the company which in turn results in its reduced earnings capacity.
  6. Liberal dividend policy: Company following too liberal dividend policy continuously for long period of time is deprived of the benefits of retained earnings. Thus, such companies fails to build up sufficient funds to replace worn-out assets and so their operating efficiency suffers and when needed company has to rely on costlier source of financing which in turn will reduce earning capacity and lead to over capitalization.
  7. Shortage of Capital: Sometimes, over capitalization may be outgrowth of shortage of capital when the firm experiences shortage of funds to meet emergent requirements compelling it to procure necessary funds at exorbitant rate of interest.
  8. Fiscal Policy: Due to the negative taxation policy a company’s tax liability increases and also it restricts the benefits of tax deductibility for depreciation. So company is left with small residual income for dividend distribution and retention. Consequently, operating efficiency of the company suffers and the state of over capitalization sets in.
  9. Promotional Expenses: Over capitalization may occur when the company incurs high promotional expenses, during which period promoters were fabulously paid high price for their services where the company does not subsequently justify this.

Effects of Over Capitalization

The state of over capitalization affects the company and its owners and also engulfs the society as a whole in the following manner.

  • Effect on Company: The effect of over capitalization on company is disastrous. Its financial stability is spoiling something important. The company loses investor’s confidence owing to irregularity in dividend payments caused by reduced earning capacity. Consequently it has to encounter enormous problem in raising capital from the capital market to satisfy it’s developmental and expansion requirements. Commercial banks too feel any shy of lending short term advances to such company to meet its working capital requirements. This will hamper production. Over capitalized concerns may at times fail to make regular payments of interest sums and repay principal amounts by the date. Under this situation creditors demand reorganization of the company. Banks and other financial institutions for similar reasons hesitate to lend. Even if they agree to grant loan terms and condition hardly acceptable.
  • Effect on shareholders: Shareholders suffer doubly the burnt of over capitalization. Because of a fall in the market value of shares, they are not in a position to dispose of their holdings profitably. On the other hand not only their dividend income fall but also it receipts becomes uncertain. They develop the feeling that the corporation is funded on shifting sands.
  • Effect on consumers: A corporation can not resist the temptation of increasing the prices of its products to inflate profits and there is every possibility that the quality of product would go down.
  • Effect on society: The over capitalized concerns suffer multi-pronged attacks from various sections of society. They are not in a position to sustain in competition. They gradually draw closer to a situation ordering liquidation while the existence of such concerns can not justified. their extinction would cause irreparable damage to society. Industrial development languishes and laborers lose employment. Wage rate declines and due to that their purchasing power declines. This tendency may permeate over the whole society and recession may follow.

Remedies of Over Capitalization

Effect of over capitalization is so grave that the management should take immediate measures to rectify the situation of over capitalization as soon as the symptoms of over capitalization are observed.

  1. Reduction in funded debt: To cut the knot of over capitalization, such firms are suggested to reduce the amount of debt to prune the amount of capital in accordance with their earnings. Redemption of debt needs additional funds which can be procured either from reinvestment of earnings or from sale of additional stock. Due to non-availability of large amount of earnings the only option available is to go to stock market. but they would find it difficult to procure money out of share capital because public response to their issue might not be encouraging.
  2. Reduction of fixed charges on debt: It is also suggested that with a view to improving earning position over capitalized concerns should slash down the burdens of fixed charges on debt for this, existing bondholders will have to be made to agree to accept new bonds carrying lower interest raw in lieu of their old holdings. The saving in interest—payment would hardly offset Premium the company would be forced to allow the bond holders in order to induce them to accept new bonds and moreover this procedure would not really reduce capitalization.
  3. Redemption of high dividend on preferred stock: In order to reduce the burden of fixed charges it is suggested that preferred stock carrying high dividend rate should be redeemed. This step will again be not useful especially of ‘cumulative’ preference shares because large amount of funds would be needed to redeem this and that would probably come from sale of common stock at low prices.
  4. Reducing par value of shares: An over capitalized concern should reduce the amount of stock outstanding by reducing par-value of shares. This is nothing but re organisation of share capital which helps the company in obscuring the real state of affairs. This is a good method but is sometimes impossible because of the stockholder’s tenacious belief in the importance of par value.
  5. Reduction in number of shares: By reducing the number of outstanding shares, efforts are made to correct over capitalization. As a result of this, earning per share tends to go up by the same proportion. This will improve credit position and share value of the company.

Watered Capital

‘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 capitalization. Water enters the capital usually in the initial period-at the time of promotion. Over capitalization can, however, be found out only after the company has worked for some time. Although watered capital can be a cause of over capitalization, 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.