Overcapitalization Causes, Adverse Effects, Corrective Measure

Banks and other financial institutions for similar reasons hesitate to lend money against such securities. Even if they agree to grant loan, they insist upon the stricter terms and conditions hardly acceptable to an ordinary borrower. As against this, others are of the view that to test the state of over-capitalisation comparison between book value and real value of shares should be made.

If a firm is unable to pay interest on borrowed funds and a fir rate of dividend on equity shares out of profit, it is said to be over-capitalized. A corporation will become overcapitalised if it borrows a significant amount of money at an causes of over capitalisation interest rate higher than the pace at which its earnings grow. The dividend rate would logically fall, and the market value of the shares would decrease, as the creditors’ revenues would strip away a significant portion of its revenues as interest. Therefore, if the market price of the shares is below the book value, the firm is over-capitalised.

Working Capital Management

Obviously, there is over-capitalisation in the company to the extent of Rs. 25,000. It may not be out of place to mention that a company is said to be over-capitalized only when it has not been able to earn fair income over a long period of time. As a matter of fact, over­-capitalisation is the consequence of prolonged irregularities. The phrase ‘over-capitalisation’ has been misunderstood with abundance of capital. In actual practice, over­capitalized concerns have been found short of funds. Truly speaking, over- capitalisation is a relative term used to denote that the firm in question is not earning reasonable income on its funds.

What are the possible causes of overcapitalization?

1. An overcapitalized company may end up paying more in interest and dividend payments than it can sustain in the long term.
2. Inadequate owned capital, defective financial plan, excessive borrowing, high interest charges, shareholders suffer — divi­dend falls and falling market value of shares.
3. In such cases, companies will have to pay more than what was earned.
4. It loses investors’ confidence owing to irregularity in dividend declaration caused by reduced earning capacity.

Businesses look for expansion with optimistic plans and acquire additional resources. If they acquire more resources than their net assets, that can soon turn into overcapitalization. As a result, the company is unable to pay a fair rate of return on the equity. Depreciation may be charged at a lower rate than warranted by the life and use of the assets, and the company may not make sufficient provisions for replacement of assets.

What Causes a Company to Become Overcapitalized?

Up until inflationary conditions take hold, higher capitalization is acceptable. In contrast, the book value of its assets stays at a greater level as the boom circumstances fade and recessionary circumstances take hold. When a company follows a liberal dividend policy; it does not have many earnings left for reinvestment purposes. This hampers growth of the company; leading to a gradual but permanent decline in its earning capacity and producing over-capitalisation.

Solutions for Overcapitalization

Industrial development languishes, and labourers lose employment. Owing to fall in purchasing power of the labour class their demand tends to decline. This tendency may gradually permeate over the whole society and recession may follow.

Over-capitalization is a financial condition that can have significant negative consequences for a company and its stakeholders. Identifying the causes and implementing appropriate remedies is essential to restore the company’s financial health and competitiveness. Assets might have been acquired at low costs during necessary conditions in the market. In almost all cases, corporate reorganization is the best solution for an overcapitalized company. Depreciation may be charged at a lower rate when compared to actual depreciation.