Capitalization, Under capitalization and Over Capitalization18/05/2020
Capitalization is an accounting method in which a cost is included in the value of an asset and expensed over the useful life of that asset, rather than being expensed in the period the cost was originally incurred. In finance, capitalization refers to the cost of capital in the form of a corporation’s stock, long-term debt, and retained earnings. In addition, market capitalization refers to the number of outstanding shares multiplied by the share price.
Capitalization has two meanings in accounting and finance. In accounting, capitalization is an accounting rule used to recognize a cash outlay as an asset on the balance sheet, rather than an expense on the income statement. In finance, capitalization is a quantitative assessment of a firm’s capital structure.
Capitalization in Finance
Another aspect of capitalization refers to the company’s capital structure. Capitalization can refer to the book value cost of capital, which is the sum of a company’s long-term debt, stock, and retained earnings. The alternative to the book value is the market value. The market value cost of capital depends on the price of the company’s stock. It is calculated by multiplying the price of the company’s shares by the number of shares outstanding in the market.
If the total number of shares outstanding is 1 billion and the stock is currently priced at $10, the market capitalization is $10 billion. Companies with a high market capitalization are referred to as large caps (more than $10 billion); companies with medium market capitalization are referred to as mid caps ($2 – $10 billion); and companies with small capitalization are referred to as small caps ($300 million – $2 billion).
It is possible to be overcapitalized or undercapitalized. Overcapitalization occurs when earnings are not enough to cover the cost of capital, such as interest payments to bondholders or dividend payments to shareholders. Undercapitalization occurs when there’s no need for outside capital because profits are high and earnings were underestimated.
Undercapitalization occurs when a company does not have sufficient capital to conduct normal business operations and pay creditors. This can occur when the company is not generating enough cash flow or is unable to access forms of financing such as debt or equity.
Undercapitalized companies also tend to choose high-cost sources of capital, such as short-term credit, over lower-cost forms such as equity or long-term debt. Investors want to proceed with caution if a company is undercapitalized because the chance of bankruptcy increases when a company loses the ability to service its debts.
Being undercapitalized is a trait most often found in young companies that do not adequately anticipate the initial costs associated with getting a business up and running. Being undercapitalized can lead to a significant drag on growth, as the company may not have the resources required for expansion, leading to the eventual failure of the company. Undercapitalization can also occur in large companies that take on significant amounts of debt and suffer from poor operating conditions.
If undercapitalization is caught early enough, and if a company has sufficient cash flows, it can replenish its coffers by selling shares, issuing debt, or obtaining a long-term revolving credit arrangement with a lender. However, if a company is unable to produce net positive cash flow or access any forms of financing, it is likely to go bankrupt.
Undercapitalization can have a number of causes, such as:
- Poor macroeconomic conditions that can lead to difficulty in raising funds at critical times
- Failure to obtain a line of credit
- Funding growth with short-term capital rather than permanent capital
- Poor risk management, such as being uninsured or underinsured against predictable business risks
Examples of Undercapitalization in Small Business
When starting a business, entrepreneurs should conduct an assessment of their financial needs and expenses—and err on the high side. Common expenses for a new business include rent and utilities, salaries or wages, equipment and fixtures, licenses, inventory, advertising, and insurance, among others. Since startup costs can be a significant hurdle, undercapitalization is a common issue for young companies.
Because of this, small business startups should create a monthly cash flow projection for their first year of operation (at least) and balance it with projected costs. Between the equity, the entrepreneur contributes and the money they are able to raise from outside investors, the business should be able to be sufficiently capitalized.
In some cases, an undercapitalized corporation can leave an entrepreneur liable for business-related matters. This is more likely when corporate and personal assets are commingled when the corporation’s owners defraud creditors, and when adequate records are not kept.
- Undercapitalized companies do not have enough capital to pay creditors and often need to borrow more money.
- Young companies that do not fully understand initial costs are sometimes undercapitalized.
- When starting, entrepreneurs must asset their financial needs and expenses then err on the high side.
- If a company can’t generate capital over time, chances of going bankrupt increase, as it loses the ability to service its debts.
Causes of Under-Capitalization:
(1) A company which is floated during depression will find itself under-capitalized during boom period. The reason being that the assets were acquired at lower cost and the return during inflation will be high.
(2) If the company is working at a high degree of efficiency it will earn more profits which will push up the real value of the shares in the market, indicating under-capitalisation.
(3) The promoters of the company at the time of preparing financial plan may under estimate future earnings or make under-estimation of capital requirements.
If the earnings, later on, prove to be higher than the estimated figure, the company will become under-capitalized.
(4) The company may follow a conservative dividend policy (i.e., moderate rate of dividend) thereby leading to enough funds for business expansion, machinery replacement etc. This will lead to higher rates of earnings and hence under-capitalisation.
(5) The promoters of the company in a desire to keep control over the affairs of the concern may issue lesser number of shares and prefer to manage with their own capital or through cheap borrowings and retained earnings, it may lead the company to under-capitalisation after some time.
Effects of Under-Capitalization:
(1) Seeing the high rate of earning and profits of the company, the employees/workers shall start demanding high salaries.
(2) High profits of the company may encourage others to enter the same business line leading to sever competition.
(3) Customers may feel that they are being exploited by the company.
(4) Company will have to pay more taxes.
Where under-capitalization arises due to inadequacy of funds:
(5) At times, company may be compelled to raise funds at higher rates of interest.
(6) Due to inadequacy of capital, once the company runs into rough weather, it may lack working capital and hence a constant danger of failure of business.
Remedial Measures to Control Under-Capitalization:
(1) The existing shareholders may be allotted shares of higher face (par) value in exchange for the old shares. This procedure will bring down the rate of earning per rupee of share value but will not affect the amount of dividend per share.
(2) The shares may be splitted up. It has the effect of reducing the dividend per share. In other words, the par value of shares may be reduced by sub-dividing the shares.
(3) The management may issue bonus shares to equity shareholders. This measure shall capitalize the earnings/products, thus increase the capitalisation and the number of shares. Dividend per share and rate of earnings will be reduced.
(4) To remove the state of under-capitalisation, fresh (more) shares and debentures may be issued.
Overcapitalization occurs when a company has issued more debt and equity than its assets are worth. The market value of the company is less than the total capitalized value of the company. An overcapitalized company might be paying more in interest and dividend payments than it has the ability to sustain long-term. The heavy debt burden and associated interest payments might be a strain on profits and reduce the amount of retained funds the company has to invest in research and development or other projects. To escape the situation, the company may need to reduce its debt load or buy back shares to reduce the company’s dividend payments. Restructuring the company’s capital is a solution to this problem.
In the insurance market, overcapitalization takes on a different meaning. Overcapitalization occurs when the supply of policies exceeds demand for policies, creating a soft market and causing insurance premiums to decline until the market stabilizes. Policies purchased in times of low premium levels can reduce an insurance company’s profitability.
The opposite of overcapitalization is undercapitalization, which occurs when a company has neither the cash flow nor the access to credit that it needs to finance its operations. The company may not be able to issue stock on the public markets because the company doesn’t meet the requirements or the filing expenses are too high. Essentially, the company can’t raise capital to fund itself, its daily operations or expansion projects. Undercapitalization most commonly occurs in companies with high start-up costs, too much debt and insufficient cash flow. Undercapitalization can ultimately lead to bankruptcy.
Causes of Over-Capitalization:
(i) More shares and/or debentures might have been issued, resulting in availability of surplus funds that cannot be profitably employed, but dividend shall have to be paid on such excess capital also.
(ii) Rate of interest on borrowings might be higher than the rate of earnings of the company.
(iii) Wrong estimate of the earnings of the company. If future earning is over-estimated, the market value of shares will fall below the purchase price because shareholders will not get what they had been promised by the company.
(iv) Floating the company under inflationary conditions will lead to over-capitalisation because of purchase of assets at high prices.
(v) Payment of high promotional expenses, i.e., if the remuneration paid to promoters etc., is very high.
(vi) Provision of depreciation lass than justified. So company will find it difficult to replace the assets (machinery etc.) with the funds made available by depreciation provision.
(vii) Insufficient and extravagant management of the company. Liberal payment of dividend and low retention of earnings for self-financing.
(viii) Time lag between installation of machinery and starting production.
(ix) High tax rates and excessive tax payment also results in over-capitalisation.
Effects of Over-Capitalization:
(i) Less earnings of the company, leading to reduction of rate of dividend and hence decrease in market value of its shares.
(ii) Shareholders of the company get less dividends.
(iii) Employees are denied increase in salaries.
(iv) Prices of company products may go high.
(v) Company finds it difficult to raise capital, because in present situation of over-capitalisation, it finds it difficult to pay a fair rate of return to its investors.
(vi) To save their skin, directors of the company may resort to unfair practices like manipulation of the books of accounts to show artificial prosperity.
Remedial Measures to Correct Over-Capitalization:
(i) All avoidable costs should be avoided e.g., purchase of new vehicles, air-conditioners, sophisticated office furniture etc.
(ii) Wastage and extravagance should be avoided.
(iii) Earning capacity should be increased by minimizing scrap and by increasing efficiency of workers.
(iv) The par value of shares or the number of shares may be reduced (to eliminate watered stock).
(v) Debentures and cumulative preference shares carrying higher rate of interest and dividend should be redeemed or their holders may be persuaded to take new debentures at lower rate of interest.