MEANING AND DEFINITION OF UNDER-CAPITALISATION
Generally, under-capitalisation is regarded equivalent to the inadequacy of capital, but it is just reverse of over-capitalisation. A company is said to be under-capitalised when its earnings are exceedingly high in relation to other similar firms in the industry, or when it has very little capital to conduct its business.
In other words, when the real value of assets are more than the book value, the company is said to be under-capitalised. It is worth noting that under- capitalisation is not always associated with shortage of capital. In fact, it is associated with an effective utilisation of investments, an exceptionally high rate of dividend and prices of shares.
Some definitions of under-capitalisation are as follows:
"When a corporation earns exceedingly high income on its capital, it is said to be under-capitalised.
Bonneville and Dewey
"When a company is earning considerably more than the prevailing rate on its outstanding securities, considering the same factors, it is said to be under-capitalised.
G Harold
The main symptoms of under-capitalisation are:
- The rate of earning is exceedingly higer than prevailing in similarly situated companies in the same industry;
- Higher rate of dividend than the rate declared by other similar companies;
- The real and market value of shares is higher than their book value;
- The real value of the company's assets is higher than their book value.
CAUSES OF UNDER-CAPITALISATION
The important causes of under-capitalisation are as follows-
Under Estimation of Earnings
If the promoters underestimate the future earnings of the company while formulating the financial plan, the amount of capitalisation will be less than what it can utilise effectively. If the earnings in subsequent years prove to be higher, the company becomes under-capitalised.
Under-estimation of Capital Requirements
If the promotors under-estimate the capital requirements of the company, the amount of capitalisation will be low and the company will become under-capitalised due to inadequacy of capital.
Promotion during Recessionary Conditions:
If a company is promoted during the period of recession, it is able to acquire the assets at cheaper prices. However, the real value of the assets automatically goes up with end of recession. Thus, during boom period its earnings will increase proportionately higher than the increase in the amount of capital employed. This would obviously, result in high profits to the company and exceptionally high rate of dividends as well as higher market price of its shares. The company, in this case, would be said to become under-capitalised.
Unforeseen Increase in Earnings
The earning of a may also increase abnormally due to government's liberal company policy towards a particular industry, or increase in sale price of the product due to sudden increase in its demand. Consequently, the company becomes over-capitalised.
Conservative Dividend Policy
If a company follows a sound and conservative dividend policy leading to the creation of sufficient reserves for depreciation, repairs and renewals, and the ploughing back of profits. Discernibly, the earnings, of such a company increased tremendously, and the real value of its assets exceeds their book value. This is indicative of under-capitalisation.
Desire of Control
If the promoters of a company want to retain its control within the hands of a few persons, they would issue lesser number of shares, and raise a large portion of its capital by issuing securities bearing low rate of interest. Consequently, the amount of divisible profits available to the shareholders will be exceptionally high and the company will become under-capitalised.
Maintenance of High Standard of Efficiency
When a company follows the policy of rationalization and modernization entailing the use of latest production techniques and efficient management of resources, its profits invariably increase exceedingly. Such a company may also increase its earnings by creating large secret reserves, ploughing back of profits, maximising productivity, minimising wasteful use of resources, etc. Consequently, the real value of its assets would be much higher than their book value, and the company would become under-capitalised.
Low Promotion Expenses
When the promoters do not charge excessive amounts for their promotional services and the over-all promotional cost is kept very low, the company will become under-capitalised.
Liberal Taxation Policy
Liberal taxation policy may also result in under-capitalisation. Due to low tax burden, sufficient amount is left with the company for higher dividend distribution, which is a symptom of under-capitalisation. Moreover, liberal taxation policy also enables the company to increase its working efficiency by maintaining adequate reserves for financing the renewels and replacement of wornout assets.
Capital Gains
Sometimes, the company's assets are sold by the management at higher prices than their book value. The resultant capital gains lead the company to under-capitalisation
FAQ
Ans: when the real value of assets are more than the book value, the company is said to be under-capitalised. A company is said to be under-capitalised when its earnings are exceedingly high in relation to other similar firms in the industry, or when it has very little capital to conduct its business.
