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, and therefore, the market value of the company becomes less than that of the capitalized value of the company. In this case, 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 ratioDebt To Equity RatioThe debt to equity ratio is a representation of the company's capital structure that determines the proportion of external liabilities to the shareholders' equity. It helps the investors determine the organization's leverage position and risk level. significantly jumped to 40.39x in 2018-19.
Components of Overcapitalization
- 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 IPOIPOAn initial public offering (IPO) occurs when a private company makes its shares available to the general public for the first time. IPO is a means of raising capital for companies by allowing them to trade their shares on the stock exchange. 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 costOpportunity CostThe difference between the chosen plan of action and the next best plan is known as the opportunity cost. It's essentially the cost of the next best alternative that has been forgiven. of its funds is high; in this case, the company reports lower earnings than expected, 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%.
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%.
- The company has excess capital or cash on the balance sheet, which can simply put the funds in the bank and can earn a nominal rate of returnNominal Rate Of ReturnA nominal rate of return is nothing but the total amount of money earned from a particular investing activity before taking various expenses like insurance, management fees, inflation, taxes, legal fees, staff salaries, office rent, and depreciation of plants and machinery the due consideration. on it, which strengthens the liquidity position of the company.
- It 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 take excess capital and cash on its balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders' equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner's capital equals the total assets of the company..
- Overcapitalization can fuel and fund the CapexCapexCapex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year. plans of the company.
- 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 because 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 to the underutilization of available resources.
- It also leads to a higher rate of taxation on the income statementIncome StatementThe income statement is one of the company's financial reports that summarizes all of the company's revenues and expenses over time in order to determine the company's profit or loss and measure its business activity over time based on user requirements. 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 debenturesDebenturesDebentures refer to long-term debt instruments issued by a government or corporation to meet its financial requirements. In return, investors are compensated with an interest income for being a creditor to the issuer.. Hence both overcapitalization and undercapitalizationUndercapitalizationUndercapitalization in business means a scenario where a company faces a shortage of funds or capital requirements to continue its day-to-day operations. The company in these moments also faces a lack of ability to procure any new source of funding or capital. 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 make a peer comparison of what is the optimal capital structure which is prevailing in the industry before deciding to make an investment decision.
This article 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 –