Causes of overcapitalization and how to overcome it in your company
Posted On May 22, 2022
Overcapitalization is, “When the company’s securities are issued in excess of their capitalized purchasing power.” Overcapitalization demoralizes shareholders who have invested their savings in stock purchases. They do not earn dividends as the company does not earn enough profits to be declared as dividends.
This state can also imply scarcity of capital. It is a capital shortage because the aggregate value of outstanding stocks and bonds exceeds the value of fixed assets. The market value of the equity shares eventually declines.
Nine causes of overcapitalization
1.) Over Stock Issuances: Due to poor planning, a company issues more stocks and debentures than it should. This translates into low income.
2.) Acquisition of assets at inflated prices: If the assets are purchased at inflated prices, the book value is low. Real asset value is low, resulting in low earnings per share.
3.) Boom Period – When a company is formed during the boom period, it experiences low profits after the boom period ends.
4.) Overestimated Profits: During the promotion stage, promoters and directors may overestimate the company’s profits, thereby raising more capital than required. This excess capital leads to lower profits.
5.) Adopting a Liberal Dividend Policy – If adopted, it leads to low profits in the long run. It results in a low book value compared to the actual value.
6.) Lack of Reserves: When a company is not making enough provisions for reserves, over capitalization occurs. This is especially the case if you distribute entire profits as dividends to shareholders.
7.) Large promotion and organization expenses: When the expenses incurred for the promotion of the company, such as the issuance and subscription of shares, the remuneration of the promoter is very high compared to his profits for the company, this results in a overcapitalization.
8.) Shortage of capital: If a company does not have enough capital, it is forced to raise additional capital through loans at high interest rates, resulting in low profits.
9.) Tax Policy: Over capitalization occurs when the policy adopted by the government is not fair. A small amount of earnings is left to cover depreciation and dividends. Your earning capacity is reduced as a result of high taxes.
Seven Ways to Overcome Overcapitalization
1.) The efficiency and productivity of human power and other company resources must be increased. Its waste must be avoided. This translates into higher profits.
2.) The company must reinvest its profits. This stabilizes the company’s profits in difficult times.
3.) There must be a reduction in the debts financed through the redemption of debentures and bonds to equalize the book value and the real value.
4.) Bond interest rates need to be lowered to ensure sufficient company profits.
5.) If the preferred stock is high dividend, then it should be redeemed.
6.) There must be a reduction in the value of the shares.
7.) The number of capital shares should be reduced.