Overview of Capitalization in Finance

Overview of Capitalization in Finance

Capitalization: Definition

The term capitalization involves debentures, the share of capital, free reserves, loans, and so on. It basically represents permanent investments in companies. But it excludes long term loans. One can easily distinguish capitalization from the capital structure. When put in contrast to capitalization, the capital structure seems to be a broader term, encompassing qualitative aspects of finance.

Types of capitalization in finance:

  1. Normal capitalization
  2. Undercapitalization
  3. Overcapitalization

We already know what normal capitalization is. It is nothing but the valuation or estimation of the current value. Let’s go ahead and discuss the other two types of capitalization.

Undercapitalization

A company that is undercapitalized is capable of incurring high profits. A company is said to be undercapitalized in which the estimated earning is quite low as compared to the actual profit. This results in additional profits, additional funds, a high level of earning, and goodwill. As a result, the company witnesses an increasing trend in the ROI. There can be different causes of under capitalization:

  • Purchasing of assets at deflated rates
  • Low promotion expenses
  • Conservative dividend policy
  • High efficiency of directors
  • Floatation of a company in the depression stage
  • Maintaining of large secret reserves
  • Adequate provision of depreciation

Consequences of undercapitalization

  • On company: Since the earning increases, therefore the company gains a huge reputation. Because of the higher rate of earnings, it starts attracting a higher level of competition in the market. The workers may start demanding more since the level of profit is quite high now. Also, the consumers may feel that the company is overcharging on kits, services, or products.
  • On shareholders: The profitability of the company increases, and therefore, the rate of earning also shoots up. Financial reputation tends to increase, and also the market value of share increases. The shareholders, therefore, can expect a high dividend.
  • On society: Because of high profitability, high earnings, and the high market price of shares, unhealthy speculation may do the rounds in the stock market. The general public may go restless as they might feel the high profit is because of the high commodity and service prices. Due to the secret reserve maintenance by companies, a low amount of tax may go to the government. The general public can have high hopes from these companies, and they can expect better technology, innovative moves, and top-notch quality products.

Overcapitalization

This situation takes place when the actual profits of a company are inadequate for payment of interests on debentures, on loans, as well as payment of dividends on shares. Over capitalization occurs most probably because the company has raised more capital than its actual need. When there is excess capital, a part of it always remains idle or stagnant. Therefore, the rate of return gradually declines. The below-given are some of the leading reasons for overcapitalization:

  • The high cost of promotion
  • Insufficient provision for depreciation purpose
  • Floatation of the company in the boom period
  • Liberal dividend policy
  • Overestimation of the total earning

Consequences of overcapitalization

 1. On public: If a company is overcapitalized, there will be many adverse effects on the public. The management indulges in tactics and malpractices like increasing the prices or decreasing the quality of the service or products. The company will not be able to pay the creditors on time. So, the public will develop a poor impression of the company. Over capitalization may lead to poor working conditions and a reduction in wages or salaries as well.

 2. On the company: Since the company is making very few profits, hence the reputation will go down. It will be difficult to market the shares of the company. The company will be forced to cut down its expenses on things like adequate depreciation, maintenance, asset replacement, and so on. It will also have to indulge in unfair tactics like manipulation of the accounts and so on.

 3. On shareholders: Because of a decline in profitability, the rate of earning of the shareholders also decreases. Also, the market price of the shares decline because of low profits.

So, this is the overall view of capitalization in finance.