What is Under Capitalization?

Concept of Under Capitalization

The phrase under capitalization should never be misconstrued with inadequacy of capital Gerstenberge says “A corporation may be under capitalized when the rate of profit is exceptionally high in relation to the return enjoyed by similarly situated companies in the same industry or it has too little capital to conduction business”. It’s against over capitalization, under capitalization implies an effective utilization of finance, a high rate of dividend & the enhanced price of share. Here the capital of the company is less in proportion to its total requirements. In this state of affairs the real worth of the assets exceeds their book value and the rate of earning is higher than a corporation is able to offer. When a company succeeds in earning abnormally large income continuously for a pretty long time symptoms of under capitalization gradually develop in the companies. Under capitalization is an index of effective and proper utilization of funds employed in the enterprises.

Causes of Under Capitalization

Point causes of under capitalization in corporation are s under:

  1. Under Estimation Of Earnings: If earnings of new venture were under estimated and the firm was capitalized accordingly, it may find itself in the state of under capitalization afterwards when its actual turns out to be much more than what was anticipated.
  2. Using Low Capitalization Rate: A company might plunge-in plight of under capitalization if it has employed relatively lower capitalization rate.
  3. Deflationary Conditions: A company formed in recessionary condition generally becomes under capitalized after recession is over. The reason is that during recession assets are brought at exceptionally low prices which bear no relation to their income producing captivity. As the period of recession abates, earning position of the company trends to improve. This will increase real value of assets while the book value of assets would remzun as earlier and the consequence would be under capitalization.
  4. Conservative Dividend Policy: A company following conservative dividend policy builds up substantially large funds available for replacement of obsolete assets and for development and expansion purposes. This improves earning position of the company.
  5. Maintaining High Standards Of Efficiency: By employing new techniques of production and rationalization of production activities. operating efficiency of a company can be improved.

Consequences of Under Capitalization

  1. On Company: Although under capitalization does not trouble if they do not do what you want financial capability and solvency of the enterprise, still the management should not be replacement towards this situation because the company may suffer in the following ways:
    1. Tax liability of under capitalized concerns increases in correspondence with an increase on the volume of profits.
    2. In view of continued rise in profitability rate, labor may demand increase in wage rates and the non-fulfillment of their demand may because discontentment among the workers. The labor management relation is embittered which may adversely affect production efficiency of the company.
    3. Limited marketability higher prices of shares may restrict the market and the stock may be traded at price below those justified by the usually high earnings.
    4. Consumer dissatisfaction seeing the excess profits the consumers may feel they are over charged.
    5. Under capitalization intensifies the degree of competition, which may have a telling effect on profit margin of under capitalized companies. High earning rates of under capitalized companies entice many entrepreneurs to set up enterprises in the same line of business.
  2. On Shareholders: Under capitalization is advantageous to stock holders in as much as they get high dividend income regularly. Because of soaring rise in share price of under capitalized concerns, shareholders’ investment in these companies appreciates phenomenally which they may encase at any time. In another way also under capitalization benefits the shareholders. They can, in periods of  necessity get loans on soft terms against the security of their shares because of high credit standing of the under capitalized concerns in the market.
  3. On Society:  Under capitalization does not pose any economic problem to society. On the contrary, it may prove boom to it. It encourages new entrepreneurs to set up new ventures and encourages the existing ones to expand. This, in result, boosts industrial production. Consumers get variety of products at relatively cheaper rates. Establishment of more firms and expansion of existing ones help mitigate the suffering of unemployed persons.

Remedies for Under Capitalization

In order to cure the condition of under capitalization, it is imminent on the part of the company to reorganize its capital structure in such a way that number of shares increases and earnings per share is reduced. For this purpose the following two measures might be helpful:

  1. Splitting the shares: Under capitalization can be corrected by splitting up the shares in order to clear case the rate of earning per share but it does not reduce the total amount of capitalization as only the par value of the stock is decreased.
  2. Increase in par value of shares: The values of assets, under this scheme, may be revised upwards and the existing shareholders may be given new shares carrying higher par (face) value. In this way, the rate of earnings will decline though the amount of dividend per share may not be affected. As a further step, the com pay may offer the shareholders a share split-up and an increase in par-value.
  3. Capitalization of Surplus of Company: If a company has adequate surplus in hand the whole or part of it can be capitalized by issue of bonus share. This will, in no way, affect the quantum of capitalization. Of course make up of capitalization will under go marked change. Thus, with issue of bonus share capital will increase along with number of shares but surplus of the company will lie reduced by the amount of bonus shares.