(2) Sometimes, the company pays a higher price to the vendors of the assets transferred i.e. the price which is more than the worth of the assets. (b) The higher rate of earnings may encourage outsiders to enter the field and increase competition. If the estimated earnings are lower, the capitalisation figure is also lower. Sometimes, the earnings prove to be much higher and the capitalisation figure previously calculated is lower. Under capitalisation implies a situation where the profits earned are exceptionally high but the capital employed is relatively small.
As such the real value of the assets is less than the book value of the assets. (i) The amount of capitalisation found under this method represents the true worth of the firm. (ii) The amount of regular working capital to carry on business operations. This theory is based on the fact that the amount of Capitalisation is deeply and intimately correlated with the amount of earnings.
- A previous version of this story was corrected to fix text in “The Changing Face of Corporate Japan” graphic to say financial and industrials sectors dominated the Nikkei 225 at the end of the ’80s, not end of ’90s.
- Companies promoted during a period of depression often experience under-capitalisation when inflation sets in because of a sudden rise in their earnings.
- (v) If a company is earning higher profits, the customers may feel that they are being overcharged by the company.
- In another sign of the great changes over the past three-plus decades, in 1989 Japanese companies accounted for 32 of the top 50 companies by global market capitalization.
(c) Where under capitalisation is due to insufficiency of capital, more shares and debentures may be issued to the public. (c) Since the shares have great value as collateral security, the shareholders are at ease in getting loans against the security of shares of an under capitalized firm. (b) The shareholders also avail capital gains because the market value of firm’s shares increases very rapidly.
Indice
Accounting and Auditing
In fact, it is an index of proper and effective utilisation of capital employed in the concern. The amount of Capitalisation is computed by both cost theory and capitalized value of earning theory. However capitalized value of earning theory is considered to be more scientific and modern. One can highlight upon the justification of the amount of capitalization by considering the earning of the concern. As such, the earning capacity of the concern has to be considered, while determining the amount of Capitalisation. On the basis of this theory, the amount of Capitalisation is equal to the Capitalisation value of expected earnings at current rate of Capitalisation.
This is also an imbalanced condition between par value of capital and the true value of fixed assets of an organization. Under-capitalization does not mean shortage of funds—rather it is indicated by the higher rate of earnings compared to the expected returns. In other words, under this situation the real worth of assets exceeds their book value. It is an imbalanced condition between par value of capital and true value of fixed assets of a concern.
(v) Payment of high promotional expenses, i.e., if the remuneration paid to promoters etc., is very high. (6) Due to inadequacy of capital, once the company runs into rough weather, it may https://1investing.in/ lack working capital and hence a constant danger of failure of business. (2) High profits of the company may encourage others to enter the same business line leading to sever competition.
(3) Showing assets at increased value due to lack of proper depreciation policy. Consumers may feel exploited because of high rate of profit. They may think that there could be a chance to reduce prices or improve quality of product—which the company is not adopting. Change in any macroeconomic factors may bring windfall gains to the company. If the company continues with over-capitalization there may be chance of its liquidation. In such situation the society will face an irreparable damage.
If the earning is not estimated correctly, the amount of capitalization would be misleading. It is the desire of every company to have a fairly capitalised situation, i. To understand this situation, it would be necessary for us to understand and analyse the situations of over and under-capitalisation of a company.
The earnings theory of capitalisation recognises the fact that true value of an enterprise depends upon its earning capacity. Thus, the essence of the above definitions is that capitalisation is the sum total of long-term securities issued by a company and the surplus not meant for distribution. (i) The total par value of all the securities -shares and debentures outstanding at a given time. It occurs when securities are raised without corresponding increase in assets.
Acquiring Assets at Inflated Prices
As such, it defines the total amount of money that is invested in the company itself. Companies can be either undercapitalized or overcapitalized. Here, we focus on the latter but we go over what it means to be undercapitalized a little further down. (ii) Management may capitalise the earnings by issuing bonus shares to the equity shareholders. This will also reduce the rate of earnings per share without reducing the total earnings of the company. The face value or the number of equity shares may be reduced in order to rectify over-capitalisation.
In case a company’s actual capitalisation is more than its fair capitalisation the company is said to be “Over capitalised”. In case the actual capitalisation of the company is less than its fair capitalisation, the company is said to be “Under capitalised”. If the earnings are not estimated correctly, the amount of capitalisation would be misleading. (ii) It is useful to ascertain the capitalisation required for a new firm. It enables the promoters to know the amount of capital to be raised. It should be noted that the term ‘capitalisation’ is used only in relation to companies and not in respect of partnership firms or sole proprietorships.
What is Capitalization?
(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. Another effective method of correcting under-capitalisation is to split up the existing stock into larger number of shares reducing the value of each share. It neither affects the total earnings of the company nor the total amount of capital of the company but still dividend per share shall reduce. The real value of an under-capitalised company is more than its book value. The profits are higher than warranted by the book value of its assets.
Thus, under-capitalisation may be called the lesser evil though both are bad. The goal of every company should be ‘proper’ or ‘fair’ capitalisation, i.e., capitalisation related to the normal earning capacity in an industry for firms over capitalisation and under capitalisation of a certain size. It occurs due to under-utilization of the existing assets and therefore, the company’s earnings go down. Sometimes, the terms watered capital and over-capitalisation are confused for each other, but it is not true.
Plough Back Earnings
(i) Under-capitalisation may lead to higher profits and higher prices of shares on the stock exchange. There may be under-estimation of capital requirements of the company by the promoters. This may lead to capitalisation which is insufficient to conduct its operations. When a small company starts, it must create a capitalization strategy that outlines how the company will use its scarce resources to start operations.
(iv) Loss on speculation, the prices of the shares of an over-capitalised company remain unstable because of speculative dealings in such shares. This malpractice further adds to the losses of the shareholders. High rates of taxation may leave little in the hands of the management to provide for depreciation, replacements and dividends.
(ii) The amount of capitalisation arrived at on the basis of earnings can be used as a standard for comparison. Iii) The relative proportion of the different securities and even the policies concerning the administration of the capital. However, the financial scholars are not unanimous regarding the concept of capitalisation. As a matter of fact, there are as many definitions as there are writers on the subject.
FAQs About the Overcapitalization and Undercapitalization
The Shareholders bear the brunt of over capitalization doubly. Not only is their capital depreciated but the income is also uncertain and mostly irregular. The earning capacity of the company should be raised by enhancing the efficiency of human and non-human resources belonging to the company. If the estimated earnings are lower, the capitalization figure is also lower. Sometimes, the earning prove to be much higher and the capitalization figure previously calculated is lower.
