Over Capitalization

If a company raises more capital (by the issue of shares and debentures and through long-term loans) than is warranted by the figure of capitalization of its earning power, the company will be said to be over-capitalized.

In other words, a company is over-capitalized when its actual profits are not sufficient to pay interest and dividends at proper rates. It follows that an over-capitalized company is unable to pay a fair return on its capital investment. Thus if a company earns Rs. 1,50,000 with the general expectation at 10 per cent, capitalization at Rs. 15,00,000 would b proper. But if the company, somehow, issues shares and debentures to the extent of Rs. 25,00,000, the rat of earning will be only 6 per cent because with surplus but idle funds profits will still remain Rs. 1,50,000. This company is over-capitalized. However, over-capitalization is not quite the same thing as excess of capital. A company is over-capitalized only because the existing capital is not effectively utilized with the result that there is a fall in the earning capacity, and consequently in the rate of dividend payable to equity shareholders. This usually leads to a decline in the market value of the shares. The chief sign of over-capitalizations is, therefore, a fall in the rate of dividend over a long-term period. This means that over-capitalization presents chronic conditions and is not based on the results of only a few years. To emphasize this point, it may be stated that “when a company has consistently (regularly) been unable to earn the prevailing rate of return on its outstanding securities (considering the earnings of similar companies in the same industry and the degree of risk involved) it is said to be over-capitalized”. Over capitalization results in the following ways:

(1) The enterprise may raise more money by issue of shares and debentures than it can profitably use. In other words, there may be large amounts of idle funds with the company. This may be done intentionally or unintentionally. Some companies, for instance, are tempted by a favorable sentiment in the market, and issue too large a number of shares.

(2) If a company borrows a large sum of money and has to pay a rate of interest higher than its rate of earning, the results will be over-capitalization. A major part of the earnings may be given away to the creditors as interest, leaving little for the shareholders. The rate of dividend is thus lowered and the market value of the shares also declines.

(3) Over-capitalization may often result when an excessive amount is paid for goodwill and for fixed assets acquired from the vendor company or from promoters or other people associated with the company, or when unduly high amounts are spent on establishment. In such cases, the price paid for the requisition of a going concern has no relation to its earning capacity.

(4) Sometimes a company acquires assets like plant, machinery and buildings during a boom period. The price paid is naturally high. If the boom disappears and a slump sets in, the real value of such assets will greatly decline and a large part of the company’s capital would be lost even though the books will still show the assets and the capital at their previous figures. Such a company is over-capitalized because its real earnings capacity will suffer a setback due to a fall in the value of assets, whereas the capital will stand at its original figures.

(5) If a company does not make sufficient provision for depreciation and replacement and distributes higher rates of profit amongst the shareholders, the company will find after some time that, while the book value of assets is high, the real, value is extremely low. The efficiency of the company is adversely affected and its earnings go down thus bringing down the market value of the shares. This is yet another case of over-capitalization.

(6) High rates of taxation may leave little in the hands of the company to provide for depreciation and replacement and dividend to shareholders. This may adversely affect its earnings capacity and lead to over-capitalization.

(7) When the promoters underestimate the capitalization rate, the capitalization may not support the expected rate of earnings and over-capitalization may result. Suppose a company’s regular profit of rs. 50,000 is capitalized at 5% (i.e., capitalization is Rs. 1, 00,000), the rate which the promoters consider sufficient to induce investors to buy the offered securities. If it is later on found that such companies cannot command capital at less than 10% the correct capitalization of the profit of 10,000 will work out at
50,000 x ——, i.e., Rs. 5,00,000.

Over-capitalisation has evil consequences from the point of view of the company, the society and the shareholders.

From the point of view of the company





From the point of view of society






From the shareholders’ point of view



(c) The shares of an over-capitalized company have relatively have relatively small value as security for loans which a shareholder may like to raise.


(e) When an over-capitalized concern tries to set its house in order through reorganization, the shareholders are the worst suffers. Re-organization would usually take the form of reduction of capital for writing off past losses. Such a reeducation has to be borne by the shareholders. In the event of liquidation too, the shareholders have to content themselves with much less than their original investment.

Remedies of over-capitalizationAn over-capitalized concern is like a person who is extremely fat. Sooner or later, he will suffer from various diseases and will come to an untimely end, unless he takes steps to reduce his weight. An over-capitalized company must, likewise, mercilessly cut all its dead weight. An over-capitalized company must, likewise, mercilessly cut all its dead weight. Its dead weight. The following remedial steps may be adopted to this end:

(i) Redemption of bonds through outright re-organizations. If bonds are redeemed with cash received through the issue of more shares, it will only make matters worse. An over-capitalized company must, therefore, go if for complete re-organization and utilize its accumulated earnings for the purpose.

(ii) Reduction of interest on bounds, if the existing debenture-holders are given new debentures carrying lower rates of interest, it will alleviate the situation created by over-capitalization. However, this can be done by offering some premium to the debenture-holders. If the said premium is more than the economy in interest payments, the measure will lose its pint.

(iii) Reduction of preferred stock. If it carries high dividend rate, this can be tried in cases where the preferred stock is cumulative.

(iv) Reduction in the number of equity shares. This can again be tried with the consent of the shareholders.

All the measures indicated above involve re-organization. It may, therefore, be suggested in conclusion that the remedy for over-capitalization lies through re-organization

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