CAPITALISATION
NEEDS OF CAPITAL:
The amount of capital needed by any concerned should also be adequate. As the capital
gives the return, the return should be reasonable. To get an appropriate return the capital
invested should also be appropriate. No businessman wants to invest if the return is not
proper. As such, every firm tries to get adequate return as the amount invested. Then
ultimately the amount invested will also be adequate. If the capital is not adequate to the
returns, then the concern may face the danger of over-capitalization or under-
capitalization. So, in order to prevent this danger, every firm should have adequate capital
keeping in view of the same.
Capitalisation comprises of share capital, debentures, loans, free reserve etc.
Capitalisation represents permanent investment in companies excluding long-term loans.
Capitalisation is generally found to be as follows:
1. Normal i.e. Optimum
2. Over
3. Under
Over-capitalistion- Over-capitaisaion is a situation in which actual profit of a company are not
sufficient to pay interest on debenture, on loans and pay dividends on shares over a period of time.
This situation arises when the company raise more capital than required. A part of capital always
remains idle with a result, the rate of return shows a declining trend. The causes can be:
1. High promotion cost. i.e. making contracts, canvassing underwriting
Commission, drafting of documents etc.
2. Purchase of assets of higher price.
3. A company floatation in boom period.
4. Inadequate provision for depreciation.
5. Liberal dividend policy.
6. Over estimation of earning.
Effect of over-capitalization:
On shareholders-
1. Profitability decrease
2. Decrease of market price of shares
3. Uncertain earnings
4. Decline of goodwill
On company
1. Reputation of company is lower
2. Company share cannot be easily marketed
3. Fresh borrowings are difficult
4. In order to retain the company’s image, the company indulges in malpractices like
manipulation of accounts to show high earnings.
5. The company cuts down its expenditure on maintenance, replacement of assets, adequate
depreciation etc.
On public-
1. In order to cover up their earnings capacity, the management indulges in tactics like
increases in prices or decreases in quantity.
2. Return on capital employed is low
3. Not able to pay its creditors on time
4. Payment of wages and salary also lesser
Under-capitalisation- An undercapitalized company is one which incurs exceptionally high profit as
compared to industry. An under capitalized company situation arise when the estimated earnings
are very low as compared to actual profits. This gives rise to additional funds, additional profit, high
goodwill, high earnings and thus the return on capital shows an increasing trend. The causes can be:
1. Low promotion cost
2. Purchase of assets at deflated rates
3. Conservative dividend policy
4. Floatation of company in depression stage
5. High efficiency of directors
6. Adequate provision of depreciation
7. Large secret reserves are maintained
Effect of under-capitalization
On shareholders
1. Profitability increases i.e. rate of earnings goes up
2. Market value of share rises
3. Financial reputation also increases
4. Shareholders can expect a high dividend.
On company:
1. With greater earnings, reputation becomes stronger
2. Higher rate of earnings.
3. Demand of workers.
4. Consumers think that the company is overcharging on products.
On society:
1. Due to high earnings, high profitability, high market price of shares, there can be unhealthy
speculation in stock market.
2. General public is developed as they link high profits with high prices of products.
3. Secret reserves are maintained for the purpose of lower taxes to government.
4. The public inculcates high expectations of those companies that can import innovations,
high technology and thereby best quality of product.
