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.
REMEDIES OF UNDER-CAPITALISATION
The following remedies are available to correct the situation caused by under-capitalisation:-
Splitting-up of Shares
The shares of an under-capitalised company may be splitted into shares of small denomination. This would lead to bring down the amount of dividend per share without affecting the total earnings and the amount of capital of the company.
Issue of Bonus Shares
The most effective way to remedy under-capitalisation is to capitalise the retained earnings of the company by issuing bonus shares. This will increase the share capital as well as the number of shares of the company. Consequently, the rate of dividend per share will come down.
Issue of Shares and Debentures
Where a company is under-capitalised due to inadequancy of capital, it may raise more capital by issuing shares and debentures. This measure will increase the share capital and number of shares of the company resulting in decline in the rate of dividend.
