Overcapitalization is a rare case in which the company has given more debt and equity than what it’s assets are worth and there is a balance sheet mismatch between both.
What is Overcapitalization?
Overcapitalization refers to a situation where the company has raised capital beyond the specific limit which is unhealthy in nature for the company. In the case of overcapitalization, the market value of the company is less than the capitalized value of the company. In the case of overcapitalization, the company ends up paying more in interest payments and dividends payments which is not possible for the company to sustain in the long term of the company’s financial situation and is not sustainable. It simply signifies that the company is not making efficient use of the fund available to it and is poor in capital management.
We note from the above overcapitalization example of Boeing wherein its annual debt to equity ratio significantly jumped to 40.39x in 2018-19.
Components of Overcapitalization
The components of overcapitalization are Debt and Equity
- Debt: The company issues debt capital to raise money and to fund capital expenditure but when a company raises debt capital in excess of what is required in this case the company is not meeting its target capital structure and makes inadequate use of the raised funds.
- Equity Securities: The company raises money in the form of equity from capital markets from the medium of IPO or FPO which results in too much capital in the hands of the company. The company, in this case, has excess cash on its balance sheet and the opportunity cost of its funds is high in this case the company reports lower earnings than expect and the shareholders lose trust in the management of the company.
XUZ company is engaged in a business of construction in the middle east and it is earning a sum of $80,000 and earns the required rate of return is 20%.
4.9 (1,067 ratings)
This implies that the fairly capitalized capital will be $80,000 / 20% = $400,000
Now if we assume that instead of $400,000, XYZ company is using $500,000 as its capital then its rate of earnings will be $80,000 / $500,000 = 16%.
This means that due to overcapitalization, the rate of return reduces from 20% to 16%.
Advantages of Overcapitalization
The following are the advantages of overcapitalization:
- The company has excess capital or cash on the balance sheet which it can simply put the funds in the bank and can earn a nominal rate of return on it which strengthens the liquidity position of the company.
- Overcapitalization results in a higher valuation of the company which means that the company in case of an acquisition or a merger can get a higher price for itself as it can excess capital and cash on its balance sheet.
- Overcapitalization can fuel and fund the capital expenditures plans of the company.
Disadvantages of Overcapitalization
The following are the disadvantages of overcapitalization:
- The rate of return of capital goes down as the company raises more and more capital from the market which makes the capital structure of the company look bad and inadequate.
- The shareholder’s confidence in the company is lost becomes of the underutilization of funds which results in a fall in the price of a market share.
- It creates problems with re-organization.
- It leads under utilization of available resources.
- It also leads to a higher rate of taxation on the income statement of the company.
- The companies shares cannot be easily marketed and also it can lead to malpractices which are often associated with manipulating the earning period or the earnings amount of the company.
- It also leads to a superior valuation of assets than what is the real value or the intrinsic value of the asset.
A company is said to be over-capitalized when its earnings are not sufficient to justify a fair return on the amount of capital raised through equity and debentures. Hence both overcapitalization and undercapitalization are not accepted in any of the economic principles or the smoothing functioning of the company as it affects the financial stability of the company and leakage in revenue. A good analyst should look at the company’s financial and statement of other compressive income in order to determine the capital structure of the company and should also do a peer comparison of what is the optimal capital structure which is prevailing in the industry before deciding to make an investment decision.
This has been a guide to what is Overcapitalization and its definition. Here we discuss the examples of overcapitalization along with its advantages, and disadvantages. You can learn more about financing from the following articles –