Everybody knows that having too much of anything is wrong, and the financial world is no exception. The term "capitalisation" in corporate finance refers to a firm's total holdings of debt and equity. As a result, it defines the entire amount of capital spent in the business. Bonds and stocks are also included in this.
Did you know?
One of the largest banks in India stated that they were "an overcapitalised firm as of now (2017)" in a conversation with ET Now.
What is Overcapitalisation?
When a company's earnings are continuously insufficient to generate a reasonable rate of return on the amount of capitalization, it is said to be over-capitalized. Moreover, a firm is said to be overcapitalised if it cannot pay the interest on its long-term debt and debentures and the fair dividend rates on its shares.
This problem typically occurs when a business raises more money than its actual earnings can support. It should be noted that overcapitalisation does not always imply an excess of capital. Because capital is not being used properly, which results in a consistent fall in profitability, the company may be overcapitalised.
In short, a firm will be seen to be overcapitalised if it cannot obtain a reasonable or prevailing rate of return on its capital. As a result, the market value of its shares has consistently fallen below the book value over time.
Causes of Overcapitalisation
There are several factors responsible for firm being overcapitalised, the most significant of which are as follows:
Exorbitant Promotional Costs
If a firm pays excessive prices for goodwill, trade names, patents, copyright, and other intellectual property, as well as significant promotional expenditures in the form of payments to marketers for their services, it may be over-capitalised.
Similar to the previous instance, if the firm was created by transforming a partnership firm or a private limited company into a public limited company and the assets were forwarded at vastly inflated prices, the firm will be over-capitalised since the book valuation of the assets will be significantly greater than its actual value.
Acquisition of assets during an inflationary period
By their very nature, inflationary conditions significantly contribute to the overcapitalisation of business enterprises and have an equal impact on newly developed and established businesses. Companies must pay high prices for fixed assets during a boom and maintain elevated capitalisation levels. Up until inflationary conditions take hold, higher capitalization is acceptable. The actual worth of the company's assets, however, declines. In contrast, the book value of its assets stays at a greater level as the boom circumstances fade and recessionary circumstances take hold. As a result, the corporation over-capitalised.
Raising Too Much Capital
If a corporation raises more capital than it can employ productively, overcapitalisation may result. In this situation, a significant proportion of capital is idle or inefficiently used. As a result, the company's earnings shrink, which causes its stock's market value to decrease. Consequently, the corporation over-capitalised.
Another reason for over-capitalisation is a lack of capital. Inadequate capital is typically the result of poor financial planning, which forces the business to borrow money at exorbitant interest rates. In this instance, a significant portion of profits is paid as interest to the creditors, leaving little money for dividends to be paid to the shareholders. The market value of shares also decreases due to the dividend rate falling, which is a sign of overcapitalisation.
Higher Interest Rate Borrowings
A corporation will become overcapitalised if it borrows a significant amount of money at an interest rate higher than the pace at which its earnings grow. The dividend rate would logically fall, and the market value of the shares would decrease, as the creditors' revenues would strip away a significant portion of its revenues as interest. Therefore, if the market price of the shares is below the book value, the firm is over-capitalised.
Over-estimation of Future Earning
When the promoters or managers incorrectly overestimate the company's earnings, this will lead to overcapitalisation because it won't produce a fair rate of return that is common in the market.
Under-estimation of Capitalisation Rate
The company would be overcapitalised even if the earnings estimates were accurate, but the capitalization rate was underestimated. Underestimating the capitalization rate causes the company to raise more money than it might profitably use. As a result, the corporation cannot pay dividends at market prices, resulting in a declining market value of its shares, which signifies overcapitalisation.
Overcapitalisation may also emerge from the government's strict taxation policies. A sign of overcapitalisation is that the company has very little money left after paying higher taxes to distribute dividends to shareholders at the current rate. Additionally, the business can run out of money for working capital and funding to substitute and restore worn-out assets. As a result, the company's productivity will decline, and the value of its shares will diminish. The corporation will therefore have excess capital.
Effects of Overcapitalisation
Effect on the firm:
Overcapitalisation has devastating effects on businesses. Something significant is being ruined by its financial stability. Investors lose faith in the company due to irregular dividend payments brought on by a decline in earning potential. As a result, it has a tough time obtaining the necessary funding from the capital market to meet its needs for growth and development. Commercial banks are also hesitant to provide such a company with short-term advances to cover its working capital needs, which will impede output. Overcapitalised businesses occasionally risk missing deadlines for principal repayment and interest payments. In this scenario, creditors demand that the corporation be reorganised. For similar reasons, banks and other financial organisations are reluctant to provide loans.
Effect on the shareholders:
Shareholders are burned twice as much by overcapitalisation, and they cannot profitably sell their holdings due to a decline in the market value of shares. On the other hand, not only does their dividend income decline, but the certainty of its receipts also does. They start to feel that shaky foundations support the company.
Effect on consumer:
The temptation to raise product pricing to boost profits is too great for a corporation to deny, and there is a good chance that the product's overall quality will suffer as a result.
Effect on society:
Different societal groups fight overcapitalised companies in a variety of ways. They cannot remain competitive, and they are edging closer to a point where liquidation is required even though the existence of these worries cannot be substantiated. Society would suffer irreparable harm if they disappeared. Worker employment declines as industrial expansion stalls. As a result of falling wages, workers' purchasing power decreases. The entire society may exhibit this propensity, and a recession may result.
Solutions for Overcapitalisation
- Overcapitalised businesses are advised to cut back on debt to trim the quantity of capital in line with their revenues to untangle the knot of overcapitalisation. Additional funds are required for the debt redemption process, and these funds can be obtained through stock sales or the reinvestment of earnings. The only option accessible is to visit the stock market because substantial earnings are not readily available. However, they would have trouble raising money from share capital because the public's reaction to their problem might not be positive. In stock markets, shares of these companies are offered at low rates. As a result, they might be forced to issue a lot of stock to raise the necessary funds. This could make the issue worse rather than better.
- It is also recommended that overcapitalised businesses reduce the weight of fixed costs on debt to improve their earnings. Furthermore, it will be necessary to convince holders of existing bonds to accept new bonds with reduced interest rates in place of their current ones. If the new bonds are offered to bondholders at a premium, they may agree to accept them. Once more, this does not make things better.
- It is sometimes recommended that a company with excessive capital should lower the par value of its shares in order to minimise the number of shares outstanding. This is nothing more than a share capital rearrangement that aids the company in concealing the actual condition of affairs.
- The visible signs of overcapitalisation are attempted to be corrected by lowering the number of outstanding shares. For instance, a corporation has 1,00,000 shares, each worth ₹10.00. The number of shares is decreased to 25,000 if the company issues one new claim in exchange for four old shares. The earnings per share then increase by the same percentage. As a result, the company's share value may increase, and its credit standing in the market may be enhanced.
Also read: What Is Inventory Carrying Cost?
In this article, we learned about overcapitalisation, which is the practice of raising more money than is necessary to provide the profit level the firm is now earning. It is also not supported by the level of revenue-generating assets currently in place and the company's future growth prospects. When such capital is generated by debt or even stock, it results in a high cost of capital burden. If the return on equity is persistently low, it results in a decline in investor trust. If a company needs to operate for an extended period, reorganising surplus capital is a wise course of action to avoid becoming trapped in a cycle of underperformance and to lessen the likelihood that it will go bankrupt, shut down, or lose the trust and money of investors.
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