Overcapitalization

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. read more significantly jumped to 40.39x in 2018-19.

Overcapitalization

Components of Overcapitalization

Overcapitalization (Components)

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%.

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

Disadvantages

  • 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 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 make 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 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 –

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