by Capitalization Concept refers to the total value of a company’s outstanding shares, including both equity and debt, which represents the firm’s overall value in the market. It is an essential concept in finance, used to assess the financial health and market standing of a company. Capitalization is typically calculated using the following formula:
Capitalization = Share Price × Number of Outstanding Shares (for equity capitalization)
or
Capitalization = Debt + Equity (for total capitalization).
- Equity Capitalization: This refers to the value of a company’s equity shares and is based on the market value of shares. It gives investors an idea of the company’s market worth and its performance in the stock market.
- Total Capitalization: This includes both debt (loans, bonds) and equity. It provides a more comprehensive picture of the company’s financial structure and the total amount invested in the business.
Basis of Capitalization:
Basis of capitalization refers to the method used to determine the capital structure of a business, combining equity and debt to fund its operations and growth. Capitalization is an essential concept for understanding a company’s financial health, and it helps in determining the financial risk, cost of capital, and valuation. There are different bases or approaches used to calculate and understand capitalization, each impacting business decisions differently.
1. Equity Capitalization
Equity capitalization focuses solely on the ownership capital of a firm. It represents the value of the company based on the market price of its equity shares. It reflects the funds raised by issuing shares to investors and the value created by the company in the form of retained earnings. Equity capitalization can be determined using the formula:
Equity Capitalization = Market Price per Share × Number of Shares Outstanding
This approach emphasizes the equity holders’ perspective and is widely used by investors to assess the market value of a company. It is especially relevant for publicly traded companies, where share prices fluctuate with market conditions. Companies with high equity capitalization are considered more financially stable and have greater flexibility in raising funds.
2. Debt Capitalization
Debt capitalization refers to the funds a company raises through loans, bonds, or other debt instruments. Companies with a high proportion of debt in their capital structure are said to be highly leveraged. The basis of debt capitalization is rooted in the cost of borrowing, interest rates, and repayment terms.
The formula for debt capitalization is:
Debt Capitalization = Long-term Debt + Short-term Debt
Firms with more debt tend to have higher financial risk due to the obligation to make fixed interest payments and repay the principal. However, debt capital is cheaper than equity because interest expenses are tax-deductible, and it can potentially lead to higher returns for equity shareholders if managed well.
3. Total Capitalization (Combined Capitalization)
Total capitalization includes both equity and debt, providing a comprehensive view of the firm’s capital structure. It reflects the total funds available to the company, which are used for its operations, expansion, and asset acquisition.
The formula for total capitalization is:
Total Capitalization = Equity Capital + Debt Capital
This combined approach is particularly useful for evaluating the overall financial strength of the business. A balanced mix of debt and equity ensures that the company can benefit from leverage while maintaining the financial stability required to handle external risks.
4. Market Capitalization
Market capitalization is a concept most commonly used for publicly traded companies. It is based on the stock market’s valuation of a company’s equity, calculated by multiplying the current share price by the total number of outstanding shares. This figure helps determine a company’s size, growth potential, and market perception. It is particularly useful for investors to assess the relative size of different firms in the market.
Sources of Capitalisation
Capitalisation refers to the process of converting eligible reserves or accumulated profits into share capital by issuing bonus shares. Under Section 63 of the Companies Act, 2013, a company may issue fully paid-up bonus shares by capitalising specified eligible reserves, subject to applicable legal conditions.
1. Free Reserves
Free reserves are accumulated profits that a company is legally permitted to distribute as dividends. They may include eligible retained earnings and general reserves. A company can use these reserves to issue bonus shares instead of distributing the profits in cash. This process transfers an amount from free reserves to the share capital account, increasing paid-up share capital without bringing fresh funds into the business.
Example: ABC Ltd. has ₹5,00,000 in eligible free reserves and capitalises ₹1,00,000 to issue 10,000 bonus shares of ₹10 each.
2. Securities Premium Account
The Securities Premium Account contains the premium received when shares are issued above their face value. Under Section 52 of the Companies Act, 2013, an eligible balance may be used to issue fully paid bonus shares, subject to the applicable provisions. This source enables a company to convert eligible securities premium into share capital while retaining its cash resources for business operations and expansion.
Example: XYZ Ltd. has ₹3,00,000 in its Securities Premium Account and uses ₹1,00,000 of the eligible balance to issue 10,000 bonus shares of ₹10 each.
3. Capital Redemption Reserve
The Capital Redemption Reserve (CRR) is created in specified circumstances, including certain redemptions of preference shares. Under Sections 55 and 63 of the Companies Act, 2013, the eligible CRR balance may be capitalised for issuing fully paid bonus shares. This process increases share capital while reducing the reserve by the corresponding amount. The company must satisfy the statutory requirements applicable to the creation and use of this reserve.
Example: PQR Ltd. has ₹2,00,000 in its Capital Redemption Reserve and uses ₹50,000 to issue 5,000 bonus shares of ₹10 each, subject to legal requirements.
4. Accumulated Retained Earnings
Retained earnings are profits remaining after deducting dividends and other appropriations from accumulated profits. To the extent that these earnings form part of eligible free reserves, they may be capitalised for issuing bonus shares. This method enables a profitable company to strengthen its paid-up share capital while keeping cash within the business. The company must ensure that the retained earnings are available for capitalisation and meet the relevant statutory requirements.
Example: LMN Ltd. has ₹4,00,000 in accumulated retained earnings included in eligible free reserves. It capitalises ₹2,00,000 to issue 20,000 bonus shares of ₹10 each.
5. General Reserve
A general reserve is created by transferring a portion of profits to a reserve account for future business needs and financial stability. Where the balance qualifies as a free reserve, the company may use it for issuing bonus shares. Capitalising the general reserve reduces the reserve balance and increases paid-up share capital by the same amount. This method is useful when the company has accumulated reserves but wishes to conserve cash for future activities.
Example: DEF Ltd. has ₹6,00,000 in its general reserve and capitalises ₹1,50,000 to issue 15,000 bonus shares of ₹10 each, provided the reserve is eligible.
Accounting Entries for Bonus Issue
Accounting entries for a bonus issue record the conversion of eligible reserves into share capital. A company issues additional fully paid-up shares to existing shareholders without receiving any additional payment. The process involves transferring an amount from eligible reserves to a temporary Bonus to Shareholders Account, followed by transferring that amount to the Share Capital Account when the bonus shares are allotted. The entries increase paid-up share capital and reduce reserves by the same amount.
Journal Entries for Bonus Issue
The accounting entries generally follow two stages:
– First entry — Capitalisation of reserves:
Relevant Reserve A/c Dr.
To Bonus to Shareholders A/c
– Second entry — Allotment of bonus shares:
Bonus to Shareholders A/c Dr.
To Equity Share Capital A/c
These entries record the transfer from eligible reserves to share capital. Some accounting textbooks combine the two stages into a direct entry by debiting the relevant reserve and crediting Share Capital.
Important Accounting Principles
Bonus shares are issued without receiving fresh cash from shareholders. Therefore, no Bank Account is debited. The amount transferred to share capital equals the face value of the bonus shares issued. Total shareholders’ funds remain unchanged immediately after the issue, although their composition changes. The company must also ensure that the number of shares allotted corresponds to the approved bonus ratio and that the entries are supported by appropriate corporate approvals.
Numerical Problems with Solutions
Numerical 1: Bonus Issue from General Reserve
Question: ABC Ltd. has a General Reserve of ₹5,00,000. It decides to issue 10,000 bonus shares of ₹10 each by capitalising the General Reserve. Pass the necessary journal entries.
Calculation:
Bonus issue amount = Number of shares × Face value
= 10,000 × ₹10 = ₹1,00,000
Journal Entries
| Particulars | Debit (₹) | Credit (₹) |
|---|---|---|
| General Reserve A/c Dr. | 1,00,000 | — |
| To Bonus to Shareholders A/c | — | 1,00,000 |
| (Being General Reserve capitalised for bonus issue) | ||
| Bonus to Shareholders A/c Dr. | 1,00,000 | — |
| To Equity Share Capital A/c | — | 1,00,000 |
| (Being 10,000 bonus shares of ₹10 each allotted as fully paid-up) |
Result: General Reserve decreases by ₹1,00,000, and Share Capital increases by ₹1,00,000.
Numerical 2: Bonus Issue from Securities Premium
Question: XYZ Ltd. has an eligible Securities Premium balance of ₹3,00,000. The company decides to capitalise ₹2,00,000 for issuing bonus shares of ₹10 each. Calculate the number of bonus shares and pass the journal entries.
Calculation:
Number of bonus shares = Amount capitalised ÷ Face value per share
= ₹2,00,000 ÷ ₹10 = 20,000 shares
Journal Entries
| Particulars | Debit (₹) | Credit (₹) |
|---|---|---|
| Securities Premium A/c Dr. | 2,00,000 | — |
| To Bonus to Shareholders A/c | — | 2,00,000 |
| (Being eligible Securities Premium capitalised) | ||
| Bonus to Shareholders A/c Dr. | 2,00,000 | — |
| To Equity Share Capital A/c | — | 2,00,000 |
| (Being 20,000 bonus shares of ₹10 each allotted as fully paid-up) |
Result: Securities Premium decreases by ₹2,00,000, and Share Capital increases by ₹2,00,000.
Numerical 3: Bonus Issue in the Ratio of 1:2
Question: PQR Ltd. has 50,000 existing equity shares of ₹10 each. The company announces a bonus issue in the ratio of 1:2 by capitalising eligible free reserves. Pass the necessary journal entries.
Calculation:
Bonus shares = Existing shares × Bonus ratio
= 50,000 × 1/2 = 25,000 shares
Amount of bonus issue = 25,000 × ₹10 = ₹2,50,000
Journal Entries
| Particulars | Debit (₹) | Credit (₹) |
|---|---|---|
| Free Reserves A/c Dr. | 2,50,000 | — |
| To Bonus to Shareholders A/c | — | 2,50,000 |
| (Being eligible free reserves capitalised) | ||
| Bonus to Shareholders A/c Dr. | 2,50,000 | — |
| To Equity Share Capital A/c | — | 2,50,000 |
| (Being 25,000 bonus shares allotted as fully paid-up) |
Result: The company issues 25,000 additional shares. The total number of shares becomes 75,000.
Numerical 4: Bonus Issue from Multiple Sources
Question: LMN Ltd. issues 30,000 bonus shares of ₹10 each by capitalising ₹2,00,000 from General Reserve and ₹1,00,000 from Securities Premium. Pass the journal entries.
Calculation:
Total bonus issue = 30,000 × ₹10 = ₹3,00,000
Sources used:
-
General Reserve = ₹2,00,000
-
Securities Premium = ₹1,00,000
Journal Entries
| Particulars | Debit (₹) | Credit (₹) |
|---|---|---|
| General Reserve A/c Dr. | 2,00,000 | — |
| Securities Premium A/c Dr. | 1,00,000 | — |
| To Bonus to Shareholders A/c | — | 3,00,000 |
| (Being eligible reserves capitalised for bonus issue) | ||
| Bonus to Shareholders A/c Dr. | 3,00,000 | — |
| To Equity Share Capital A/c | — | 3,00,000 |
| (Being 30,000 bonus shares of ₹10 each allotted as fully paid-up) |
Result: General Reserve decreases by ₹2,00,000, Securities Premium decreases by ₹1,00,000, and Share Capital increases by ₹3,00,000.
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