MEANING AND DEFINITION OF OVER-CAPITALISATION
A company is said to be over-capitalised when its earnings are consistently insufficient to yield a fair rate of return on the amount of capitalisation. In other words, when a company is not in a position to pay interest on debentures and long-term borrowings, and dividends shares at fair rates, it is said to be overcapitalised.
This situation will normally arise when a company raises more capital than what is justified by its actual earnings. It may be noted that over-capitalisation does not necessarily mean abundance or excess of capital. Company may be over-capitalised because its capital is not effectively utilised, thus causing a constant decline in earnings. This leads to the inability of the company to pay normal rate of dividend and interest on shares and debentures respectively, and the .consequent fall in the market value of its shares.
In essence, if a company has been unable to earn a fair or prevailing rate of return on its capital, and consequently the market value of its shares is lower than the book value over a fairly long period of time, the company will be said to be overcapitalised.
Some definitions of over-capitalisation are as follows:
"When a company has consistently 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), it is to be over-capitalised.
Harold Gilbert
"Whenever the aggregate of the par value of stock and bonds outstanding exceeds the true value of fixed assets, the corporation is said be over-capitalised."
Hoagland
Thus, there are three main symptoms of over-capitalisation:-
- Lower rate of earning than prevailing in similar companies in the same industry over a fairly long period of time.
- Lower rate of dividend over a long period of time.
- Lower market value of shares than the book value of shares over a long period of time.
CAUSES OF OVER-CAPITALISATION
The causes of over-capitalisation are as follows:-
High Promotion Expenses
Company may be over capitalised if it has paid high promotional expenses in the form of payments to promoters for their services, and excessive price for goodwill, trade marks, patents, copyright, etc. Similarly, if the company was formed by converting a partnership firm or a private limited company into a public limited company and the assets were transferred at highly inflated prices, the company will be over-capitalised because the book value of the company's assets will be higher than its real value.
Purchase of Assets During Inflationary Conditions
By its nature, inflationary conditions are an important factor in over capitalisation of business enterprises, and equally affect both the newly promoted as well as the established companies. During boom period, companies have to pay high prices for purchases of fixed assets, and the amount of capitalisation is kept high. Higher capitalisation is justifiable until inflationary conditions prevail. But when the boom conditions subside and recessionary conditions set in, the real value of the company's assets fall whereas the book value of its assets remain at a, higher level. Consequently, the company becomes over-capitalised.
Raising Excessive Capital
Over-capitalisation may be caused in a company if it raises excessive capital than what it can utilise effectively. In this case, a large amount of capital remains either idle or ineffectively utilised. Consequently, the company's earnings decline which lead to fall in market value of its shares. Thus, the company becomes over-capitalised.
Shortage of Capital
Paucity of capital is also one of the causes of over-capitalisation. Inadequacy of capital is, generally, the result of faulty financial planning, and compells the company to borrow capital at very high rates of interest. In this case, a large chunk of profits is given away to the creditors as interest leaving little to be distributed to the shareholders as dividends. Due to fall in rate of dividend, the market value of shares also fall which is the symptom of over-capitalisation.
Borrowings at Higher Interest Rates:
If a company borrows large amount of capital at higher rate of interest than the rate of its earnings to meet its emergent needs, the company would be ultimately over-capitalised. Since a major part of its earnings is taken away by the creditors as interest, the rate of dividend would naturally fall, and the market value of shares would decline. Thus, lower market price of shares than the book value would make the company over-capitalised.
Over-estimation of Future Earning
When the promoters or managers wrongly over-estimate the earnings of the company, this would result in over-capitalisation as it would not yield a fair rate of return prevalent in the market,
Under-estimation of Capitalisation Rate
Even if the earnings are correctly estimated but the rate of capitalisation is under-estimated, the company would be over-capitalised. Under estimation of the rate of capitalisation results in raising excessive capital than what the company could utilise profitably. Consequently, the company is unable to distribute dividends at prevailing rates. The leads to decline the market value of its shares which a symptom of over-capitalisation.
Inadequate Provision for Depreciation
If a company does make adequate provision for depreciation and replacement of assets, it will be able to distribute higher dividends to its shareholders for years. However, with the a few passage of time the working efficiency of fixed assets will decrease resulting in a fall in the earning capacity company. Consequently, the share of the declining trend which would prices of the company will show a indicate over-capitalisation.
Liberal Dividend Policy
Sometimes a company prefers to follow a liberal dividend policy instead of ploughing hack its profit. In the long-run, such company would find it difficult to replace its wornout assets with sufficiently decreased working efficiency. Moreover, the company is compelled to resort to costly borrowing which adversely affects its earning capacity. The combined effect of these factors leads the company to over capitalisation over a long period of time.
Rigorous Taxation Policy
Rigorous taxation policy of the Government may also result in over-capitalisation. Due to higher tax burden, very little amount is left with the company for dividend distribution among the shareholders at a prevailing rate, which is a symptom of overcapitalisation. Moreover, the company may face shortage of funds for both working capital as well as for financing the renewals and replacements of wornout assets. Consequently, the working efficiency of the company will be decreased, and the prices of its shares will fall. Thus, the company will be over-capitalised.
FAQ
Ans: A company is said to be over-capitalised when its earnings are consistently insufficient to yield a fair rate of return on the amount of capitalisation.
