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 in increasing 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 us say there is a corporation that deals with the import and distribution business. The stakeholder will keep an eye on debts, the rate of returns, and bookkeeping and will effectively plan to increase the capital 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, 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 that are not being utilized to gain profit.
Suppose a company has any one of the above indicators. In that case, the company might go to a state of over-capitalization at the start. Stakeholders must keep a thoughtful eye on the debts, equity, rate of return, and the business’s balance sheets. Bookkeeping must also be monitored to check if the transactions are precise. This vigilance will lead the company in the right direction.
Other causes of overcapitalization and effective management
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 more significant than the actual cost of its assets.
- A lot of money was spent on the promotion of the business. Though promotion increased the rate of return, it was not enough to compensate for 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 the invested capital. In that case, the share or rate of return per asset would be decreased significantly. More investment, lesser profit leads to overcapitalization.
- 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. This type of management may lead to overcapitalization in the near future.
- Inefficient management is also a cause of overcapitalization. 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 transaction was recorded, and the amount of return is generated.
Remedies for overcapitalization
Over capitalization of firms leads to an unhealthy business, or it may cause the end of a business. The company must be restructured to avoid the situation of the company going downhill quickly.
Other solutions for overcapitalization involve the following:
- Decrease the burden of debt by effectively utilizing the profit for earlier debt payments.
- Effectively negotiate with lenders to reduce interest rates in debt.
- Develop a scheme of capital reduction to gain more profit per asset.
- A company with overcapitalization can merge with high-profit companies with a better management system willing to take over other companies.
By making proper estimates and better management, a company with overcapitalization can be profitable and prosperous again.
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