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 and other funding sources. Otherwise, there will be no monetary profit.
A successful business increases its rate of return by developing policies on the invested capital, using profits, and overcoming debts. Investors look at how the returned amount of business can be used to maximize the rate of return. For example, let’s say a corporation deals with the import and distribution business. The stakeholder will look at debts, the rate of returns, and bookkeeping but also will effectively plan to increase the capital amount by adding some percent from the profit previously gained.
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.
- If a company has any one of the above indicators, then the company might go to a state of over-capitalization without coming into the notice of stakeholders at the start. Stakeholders must keep a thoughtful eye on the debts, equity, rate of return, and the balance sheets of the business. Bookkeeping must also be monitored and vigilantly followed to check if the transactions were precise. This will lead the company in the right direction.
The following are the other causes of over-capitalization and effective management to avoid these causes as much as possible
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 greater 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 of the invested capital. In that case, the share or rate of return per asset would be decreased significantly. More investment, lesser profit leads to over-capitalization.
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. Such kind of management may lead to over-capitalization in the near future of the company.
- Inefficient management is also a cause of over-capitalization. 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.