Overcapitalization: Definition and Explanation

Overcapitalization occurs when funds of a long-term nature (e.g., share capital, debentures, and loans) exceed the amount of optimal capitalization.

According to Hoagland, overcapitalization can be defined as follows:

Whenever the aggregate of the par-values of stocks and bonds outstanding exceeded the true value of the fixed assets, the corporation is said to be over-capitalized.

If capitalized optimally, a company will earn a good return on its investment. By contrast, if is it overcapitalized, the company will have a rate of return that is lower than the rate of return in competing firms.

Declining rates of return and dividend rates are strongly suggestive of overcapitalization. If overcapitalization is an issue, the supply of long-term funds exceeds the required amount of funds, or the economic activities of the enterprise decelerate.

Overcapitalisation, in other words, refers to the underutilization of funds. That’s to say, a company is overcapitalized when its actual profits are not sufficient to pay interest and dividends at proper rates.

For overcapitalized companies, total profit may increase but the rate of earnings will decline.

Causes of Overcapitalization

Common causes of overcapitalization in a business are the following:

Idle Funds

The promoters of a company may issue more than the required number of shares and debentures, and these funds may remain idle. Such funds will not earn a return, whereas investing them may yield a high return.

The result of idle funds, therefore, is a lower rate of return.

Underutilization of Funds

A company’s return is compromised when funds are improperly used. In particular, underutilization of funds will yield low earnings, resulting in the decline of return per share.

Acquisition of Goodwill at Excessive Price

When companies are acquired, the company may pay for goodwill more than its net worth. Goodwill is a fictitious asset that has no real worth.

Therefore, if excessive funds have been allocated to the acquisition of goodwill, a lower amount of funds will be available for use. Consequently, the rate of return will decline.

Acquisition of Fixed Assets When Prices are Higher

An enterprise may have acquired assets at a time when it was very costly to do so. With the passage of time, the price of these fixed assets, initially purchased earlier at a higher price, may decrease. If so, the reduction in the real value of assets will reduce earnings.

Inadequate Provision for Depreciation

Depreciation may be charged at a lower rate when compared to actual depreciation. The result will be a reduction in the real value as compared to the book value. The reduction in the real value of assets will lead to low earnings and overcapitalization.

Excess of Rate on Loans over the Rate of Return on Funds

Sometimes, the rate of interest on loans received may exceed the rate of earnings on the investment. In such cases, companies will have to pay more than what was earned. The situation will result in declining returns and, in turn, overcapitalization.

Higher Rate of Taxation

Higher taxation rates may consume a large portion of earnings and, in this way, deprive shareholders of a dividend at a fair rate. This situation will lead to the overcapitalization of the company.

Adverse Effects of Overcapitalization on Company, Society, and Shareholders

The economic consequences of overcapitalization may be fatal for a company, its shareholders, and society as a whole.

(a) Effects on Company

The company is adversely affected due to overcapitalization in the following ways:@
1. Decline in dividend rate: A declining dividend rate due to overcapitalization undermines a firm’s reputation and future prospects.
2. Fundraising difficulties: When the dividend rate falls, the market value of shares also falls. Under such circumstances, fundraising becomes difficult for the company.
3. Malpractice: To show a respectable profit, the company may engage in manipulation, window dressing, and malpractice.
4. Considerable loss of goodwill: To counter the adverse effects of overcapitalization, a company may undergo reorganization. This reduces the par value of shares, the dividend rate on preference shares, and interest rates on debentures. This leads to the loss of goodwill.

(b) Effects on Society

Society is also the victim of overcapitalization, often suffering in the following ways:
1. Higher prices: To increase the dividend rate, a company may increase its prices. These higher prices are often passed on to consumers.
2. Lower quality: To increase its profit, an overcapitalized company may focus on reducing production costs by lowering quality, again having a negative impact on consumers.
3. Lower wages: To reduce the cost of production, a company may lower wages, thereby causing employees to suffer and potentially exerting broader macroeconomic effects.
4. Misuse of societal resources: Important societal resources, when invested in an overcapitalized company, are not effectively used. As such, overcapitalization leads to resource misuse, which has a substantial cost for society.
5. Gambling on the stock exchange: The share price of overcapitalized companies tends to fluctuate in a volatile way. This provides scope for gambling with the company’s shares.

(c) Effects on Shareholders

Overcapitalization affects shareholders adversely in the following ways:
1. Loss of share value: Shareholders are the worst losers in case of overcapitalization. Lower rates of earning and dividends reduce the value of their shares.
2. Low return on investment: Shareholders do not receive a fair and competitive return on their investments because overcapitalized companies tend to earn minimal profits.
3. Speculative gambling: Fluctuations in share value create opportunities for gambling in shares.
4. Losses due to reorganization: The general remedy for overcapitalization is corporate reorganization (i.e., the reduction in the par value of shares). As such, shareholders are again the worst sufferers.

Corrective Measures to Limit the Negative Effects of Overcapitalization

An overcapitalized company can be likened to an obese person who lacks mobility due to excessive weight. Unless countermeasures are adopted to combat obesity, the situation is dire for such an individual.

In the same way, an overcapitalized company suffers from various adverse effects. It will face dissolution unless corrective measures are adopted. Examples of effective corrective measures include:

1. Reduction in the par value of shares: This is a common practice used to relieve a company from the pressures of overcapitalization.

For example, the company’s shares valued at $100 per share may be reduced to 100,000 shares valued at $50 each. In this way, the subscribed capital of the company will fall from $10,000,000 to $5,000,000.

2. Reduction in the number of shares: In this case, the number of shares is reduced to combat the negative effects of overcapitalization. In the previous example, reducing 100,000 shares to 50,000 shares at $100 per share will reduce the subscribed capital to $5,000,000.

3. Reduction in the dividend rate of preferred stock: In the case of commutative preference shares, the company may reduce the dividend rate on preference shares in consultation with preference shareholders.

In almost all cases, corporate reorganization is the best solution for an overcapitalized company.

Frequently Asked Questions

What is overcapitalization?

Overcapitalization refers to a situation where a company has excessive capital compared to the normal level of investment required for a specific business venture. For example, there may be too much money invested in plant and equipment or other assets that have limited applications. In other words, overcapitalization occurs when a company has more capital than is normally required to carry on a business.

What are the possible causes of overcapitalization?

There can be several factors that may cause a company to become overcapitalized. Some of the key factors include poor accounting records, miscalculation of capital needs, abuse by management of shareholders’ funds, and poor financial analysis.

What are the effects of overcapitalization?

Overcapitalization leads to several adverse effects on a company, including the following: - increased liabilities - the reduced worth of shareholders’ shares - losses because of lower returns on investment - reducing dividends payable to investors in commutative preference shares - losses due to reorganization when a company becomes insolvent enough to warrant it

Why is it important to know about overcapitalization?

It is crucial that professionals are aware of the negative effects of overcapitalization because their actions can have a significant impact on shareholders’ interests. To avoid adverse effects due to overcapitalization, it is advisable for cpas and financial advisors to take proactive steps.

How can an overcapitalized company be corrected?

The first step for a company to correct the situation is by carrying out adequate internal investigations. The findings of such investigations should help management determine if management abuse, miscalculation of capital needs, or poor Financial Statements are the primary causes. If so, then corrective measures may include reducing dividends payable, reducing the number of shares by way of share buybacks, or increasing the par value of existing shares.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

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