Meaning and Definition:
Generally over-capitalization implies that the capital of the company exceeds its requirements. A company is overcapitalized when its earning capacity does not justify the amount of capitalization. In other words, a company is said to be overcapitalized when its actual profits are not sufficient to pay interest (on debentures and borrowings) and dividends (on share capital) at fair rates. In the words of Beacham, “Overcapitalization occurs when securities in the company are issued in excess of its capitalized earning power.” In the words of Hoagland, “Whenever the aggregate of the par value of its of stocks and bonds outstanding exceeds the true value of its assets, the corporation company is said to be overcapitalized.”. In the words of Charles W. Gerslenberg, “A corporation (company) is overcapitalized when its earnings are not enough to yield a fair return on the amounts of stocks and bonds that have been issued or when the amount of securities outstanding exceeds the current value of the assets.”
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Reasons:
ADVERTISEMENTS:
The main causes of over-capitalization are (i) Promotion of company with overvalued assets, (ii) Purchase of assets during boom period, i.e., at higher prices; (iii) High promotional expenses; (iv) Raising excessive capital, i.e., more capital than what it can profitably use; (v) Borrowing money at high rates of interest; (vi) Overestimation of earnings: (vii) Under provision of depreciation; (viii) High rate taxation; (ix) Lack of reserves; (x) Liberal dividend policy etc.
Merits/Advantages:
The main advantages or merits of overcapitalization are:
- Increase in the competitive power of the company.
- Easy expansion of the company’s activities.
- Morale of the management is raised.
- Risk-taking capacity is increased.
- No fear of shortage of capital.
- Power to face depression period is increased.
Demerits/ Disadvantages:
ADVERTISEMENTS:
Form Company’s Point View: (i) It reduces the earning capacity of the company; (ii) Reputation and goodwill of the company is adversely affected, i.e., reduced; (iii) Company takes resort to unfair practices; (iv) Manipulation of accounts etc. by the company; (v) Feeling of instability is developed; (vi) Fear of winding up of a company; (vii) Borrowings on higher rate of interest.
From Investor’s or Shareholder’s Point of View: (i) Loss in the value of investment (shares); (ii) Loss of easy marketability; (iii) Irregular, uncertain and lower earnings on the investment (dividend on shares); (iv) Speculation is encouraged; (v) Reduction in the liquidity of investment; (vi) Shares cannot be mortgaged easily as their utility as collateral security is reduced; (vii) Loss due to reorganization and liquidation etc.
From the Point of view of the Society: (i) Increase in prices or reduction in quality of goods; (ii) Wage cuts or retrenchment of workers; (iii) Increase in unemployment; (iv) Encouragement to reckless speculation; (v) Mis utilization and wastage of resources; (vi) Reduced efficiency of the management; (vii) Loss of public confidence in investment etc.