• Skip to primary navigation
  • Skip to main content
  • Skip to footer
WallStreetMojo

Wallstreet Mojo

Wallstreet Mojo

MENUMENU
  • Resources
        • Financial Statement Analysis

          • Ratio Analysis
          • Profitability Ratios
          • Turnover Ratios
        • Financial-Statement-Analysis
        • Accounting Basics

          • Income Statement
          • Balance Sheet
          • Cash Flow in Accounting
        • Accounting-Basics
        • Accounting Concepts

          • Assets in Accounting
          • Liabilities in Accounting
          • Shareholders Equity
        • Accounting-Concepts
        • Investment Banking Guides

          • Investment Banking
          • What is LBO?
          • What is Pitch Book?
        • Investment Banking Guides
        • Valuation

          • Discounted Cash Flow
          • Dividend Discount Model
          • Terminal Value
        • Valuation
        • Others

          • Resources (A to Z)
          • Financial Modeling
          • Financial Certifications
          • Equity Research
          • Private Equity
          • Excel
  • Free Courses
  • All Courses
        • Certification Courses

          Certificate
        • All in One Financial Analyst Bundle

          Financial-Analyst-Bundle
        • Accounting Course

          Accounting-Course
        • Investment Banking Course

          Investment-Banking-Training
        • Others

          • Equity Research Course
          • Financial Modeling Course
          • M&A Course
          • Valuation Course

          • Private Equity Course
          • Venture Capital Course
          • US GAAP Course
          • View All
  • 250+ Courses All in One Bundle
  • Login

Overcapitalization

Home » Financial Statement Analysis » Debt Ratios » Overcapitalization

By Harshada Khot Leave a Comment

Overcapitalization

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.

Overcapitalization Examples

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%.

Popular Course in this category
Cyber Monday Sale
All in One Financial Analyst Bundle (250+ Courses, 40+ Projects) 250+ Courses | 40+ Projects | 1000+ Hours | Full Lifetime Access | Certificate of Completion
4.9 (1,067 ratings)
Course Price

View Course

Related Courses
Accounting CourseInvestment Banking CourseEquity Research Course

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.

Conclusion

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.

Recommended Articles

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 –

  • Capital Market Theory
  • Opportunity Cost Examples
  • Top 4 Examples of Acquisitions
  • Examples of Merger
  • Calculate Debt Ratio
  • Calculate Debt to Asset Ratio
  • Calculate Debt Yield Ratio
  • Debt to Income Ratio Formula
0 Shares
Share
Tweet
Share

Filed Under: Debt Ratios, Financial Statement Analysis

Reader Interactions
Leave a Reply Cancel reply

Your email address will not be published. Required fields are marked *

Footer
COMPANY
About
Reviews
Blog
Contact
Privacy
Terms of Service
FREE COURSES
Free Finance Online Course
Free Accounting Online Course
Free Online Excel Course
Free VBA Course
Free Investment Banking Course
Free Financial Modeling Course
Free Ratio Analysis Course

CERTIFICATION COURSES
All Courses
Financial Analyst All in One Course
Investment Banking Course
Financial Modeling Course
Private Equity Course
Business Valuation Course
Equity Research Course
CFA Level 1 Course
CFA Level 2 Course
Venture Capital Course
Microsoft Excel Course
VBA Macros Course
Accounting Course
Advanced Excel Course
Fixed Income Course
RESOURCES
Investment Banking
Financial Modeling
Equity Research
Private Equity
Excel
Books
Certifications
Accounting
Asset Management
Risk Management

Copyright © 2019. CFA Institute Does Not Endorse, Promote, Or Warrant The Accuracy Or Quality Of WallStreetMojo. CFA® And Chartered Financial Analyst® Are Registered Trademarks Owned By CFA Institute.
Return to top

WallStreetMojo

Free Ratio Analysis Course

Step by Step Guide to Calculating Financial Ratios in excel

By continuing above step, you agree to our Terms of Use and Privacy Policy.

Free Investment Banking Course

IB Excel Templates, Accounting, Valuation, Financial Modeling, Video Tutorials

By continuing above step, you agree to our Terms of Use and Privacy Policy.

Free Investment Banking Course

IB Excel Templates, Accounting, Valuation, Financial Modeling, Video Tutorials

By continuing above step, you agree to our Terms of Use and Privacy Policy.
WallStreetMojo

Free Investment Banking Course

IB Excel Templates, Accounting, Valuation, Financial Modeling, Video Tutorials

By continuing above step, you agree to our Terms of Use and Privacy Policy.

* Please provide your correct email id. Login details for this Free course will be emailed to you

Download Colgate Ratio Analysis Template

By continuing above step, you agree to our Terms of Use and Privacy Policy.
WallStreetMojo

Free Investment Banking Course

IB Excel Templates, Accounting, Valuation, Financial Modeling, Video Tutorials

By continuing above step, you agree to our Terms of Use and Privacy Policy.

* Please provide your correct email id. Login details for this Free course will be emailed to you

WallStreetMojo

Free Investment Banking Course

IB Excel Templates, Accounting, Valuation, Financial Modeling, Video Tutorials

By continuing above step, you agree to our Terms of Use and Privacy Policy.

* Please provide your correct email id. Login details for this Free course will be emailed to you

CYBER WEEK OFFER - All in One Financial Analyst Bundle (250+ Courses, 40+ Projects) View More