Over capitalization in a company occurs when the total capital (debt & equity of the stockholders) of a company surpasses the actual value of its assets. Corporations must produce more in earnings than the money invested to increase the capital invested by stockholders such as bondholders, shareholders, and other funding sources. Otherwise, the firm does not earn a monetary profit.
A successful firm increases its rate of return by developing policies on the invested capital, utilization of monetary profits and overcoming barriers and debts. Investors thoughtfully look at how the returned amount of business can be utilized further to maximize the rate of return. For example, let’s say there is a corporation that deals with the import and distribution business. Now the stakeholder will not only keep an eye on debts, the rate of returns and bookkeeping but also will effectively plan to increase the capital amount by adding some percent from the profit previously gained. In the above-said corporation of the import and distribution business, the investors will successfully incorporate the profit by importing more quantity and by increasing the area of distribution and managing more clients.
Indicators of over-capitalization
- The money invested in the business is much greater than the actual value of its fixed assets.
- The rate of return is too low as compared to investment.
- Part of the investment capital is invested in assets which are not being utilized to gain profit.
If a company has any one of the above indicators, then the company might go to a state of over-capitalization without coming into the notice of stakeholders in the start. Stakeholders must keep a thoughtful eye on the debts, equity, rate of return and the balance sheets of the business. Bookkeeping must also be monitored and vigilantly followed to check if the transactions were precise. This will lead the company in the right direction.
Following are the other causes of over capitalization and effective management to avoid these causes as much as possible
Over capitalization may also happen due to many other factors:
- Assets were purchased when their value/price was at the peak. After some time, the actual cost of those assets decreased down to its minimal range. In that case, the investment capital will become greater than the actual cost of its assets.
- A lot of money was spent in the promotion of the business. Though promotion increased the rate of return, it was not enough to compensate the promotional costs.
- The board of directors of the company gained a handsome rate of return, they invested a plentiful amount of this profit into the business. But, the business assets do not have as much value in the market as of the invested capital. In that case, the share or rate of return per asset would be decreased significantly. More investment, lesser profit leads to over capitalization.
- The company follows a liberal policy on the division of profit gained to its stakeholders. Thus, not keeping a sufficient amount of profit gained for further self-financing in the company. Such kind of management may lead to over capitalization in the near future of the company.
- Inefficient management is also a cause of over capitalization. Management must keep a thoughtful eye on all bookkeeping aspects. Keep a routine check and balance over the purposes (like for promotion and other offers) for which a transactions were recorded and the amount of return is generated.
Remedies for over capitalizationOver capitalization of firms leads to an unhealthy business or it may cause the complete end of a business. The company must be restructured to avoid the situation of the company going down hill quickly.
Other solutions for over capitalization involves the following :1. Decrease the burden of debt by effectively utilizing the profit for an earlier debt payment.
2. Effectively negotiate with lenders to reduce interest rates in debt.
3. Develop a scheme of capital reduction to gain more profit per asset.
4. A company with over capitalization can merge with high profit companies with a better management system which is also willing to take over other companies.
Making proper estimates and with better management, a company with over capitalization can be made profitable and successful again.
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