Capital plays an important role in any business. Capitalisation refers to the long term indebtedness and includes both the ownership capital and the borrowed capital. Capital and Capitalisation are two different terms. The term 'capitalisation' is used only in relation to companies and not in respect of partnership firms or sole proprietorships. It is distinguished from capital which represents total investment or resources of a company. It thus represents total wealth of the company. It should be distinguished from share capital which refers only to the paid up value of the shares issued by the company and definitely excludes bonds, debentures, loans and other form of borrowings. Capitalisation means the total par value of all the securities, i.e. shares and debentures issued by a company and reserves, surplus and value of all other long term obligations. The term thus includes the value of ordinary and preference shares, the value of all surplus – earned and capital, the value of bonds and securities still not redeemed and the value of long term loans. Capitalisation is thus the sum total of all long term funds available to the firm along with the free reserves. According to E.T. Lincoln capitalisation is "a word ordinarily used to refer to the sum of outstanding stocks and funded obligations which may represent fictitious values". According to Gerstenbug, capitalisation is that which "comprises of a company's ownership capital which includes capital stock and surplus in whatever form it may appear and borrowed capital which consists of bonds or similar evidences of long-term debt".
A company is said to be over capitalised when its earnings are not sufficient to yield a fair return on the amount of shares or debentures. IN other words, when a company is not in a position to pay dividends and interests on its shares and debentures at fair rates, it is said to be over capitalised. It means that an over-capitalised company is unable to pay a fair return on its investment. According to Hoagland, "whenever the aggregate of the par values of stocks or bonds outstanding exceeded the true value of the fixed assets the corporation is said to be over-capitalised". According to Gerstenberg, "a corporation is over-capitalised when its earnings are not large enough to yield a fair return on the amount of stocks and not large enough to yield a fair return on the amount of stocks and bonds that have been issued or when the amount of securities outstanding exceeds the current value of assets".
Over-capitalisation is not synonymous with excess capital. Excess of capital may be one of the reasons for over-capitalisation. A company is over capitalised only because of its capital and funds not being effectively and profitably deployed with the result that there is a fall in the earning capacity of the company and in the rate of dividend to be paid to its shareholders as well as a fall in the market value of its shares.
Causes of Over-capitalisation
Floating of excess capital.
Purchasing property at an inflated price.
High cost of promotion.
Borrowings at a higher than normal rate.
Purchase of assets in the boom period.
Incorrect capitalisation rate applied.
Insufficient provision for depreciation.
High rates of taxation.
Liberal dividend policy.
Wrong estimation of future earnings.
Remedial measures to correct Over-capitalisation
Reduction of funded debts.
Reduction of interest on debentures and loans.
Reduction of preference shares.
Reduction of face value of the shares.
Reduction in the number of equity shares.
Ploughing back of profits.
Effects of Over-capitalisation
Loss of goodwill.
Difficulty in obtaining capital.
Window dressing of accounts.
Decline in efficiency.
Loss of Market.
Low rate of dividend.
Fall in the Market value of shares
Loss on re-organization.
Small value of collateral.
Reduction in quality.
Cuts in wages.
Misapplication of society's resources.
Gambling in shares.
Setback to industry.
Under-capitalisation is just reverse of over-capitalisation. The state of under-capitalisation is where the value of assets are much more than it appears in the books of the company. In well established companies, there is a large appreciation in assets, but such appreciation is now shown in the books. As against over-capitalisation, under-capitalisation is associated with an effective utilisation of investments, an exceptionally high rate of dividend and enhanced prices of shares. In other words, the capital of the company is less in proportion to its total requirements under the state of under-capitalisation. In the words of Gerstenberg, "A corporation may be under-capitalised when the rate of profits it is making on the total capital is exceptionally high in relation to the return enjoyed by similarly situated companies in the same industry or when it has too little capital with which to conduct its business".
Under-capitalisation is a condition where the real value of the company is more than its book value. The assets bring profits but it would appear to be much larger than warranted by book figures of the capital. In such cases, the dividend will naturally be high and the market value of shares will be much higher. Under-capitalisation and inadequacy of capital are regarded as inter-changeable terms but there is a difference between these two terms. Under-capitalisation does not mean inadequacy of capital. Profits are high in such companies and a part of the profits are ploughed back in the business directly or indirectly. The value of assets are shown at lower price than their real value. It means that there are secret reserves in under-capitalised companies.
Causes of Under-capitalisation
Under estimation of capital requirements.
Under estimation of future earnings.
Promotion during deflation.
Narrow dividend policy.
Desire of control.
Excessive depreciation provided.
Maintenance of high efficiency.
Difficulty in procurement of capital.
Remedies of under-capitalisation
Splitting up of shares.
Increasing the number of shares.
Increase in the par value of shares.
Issue of Bonus shares.
Fresh issue of shares.
Effects of Under-capitalisation.
Limited marketability of shares.
Dissatisfaction of customers.
Inadequacy of capital.
Secret reserves and window dressing of accounts.
Manipulation of share values.