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Compare Overcapitalization & undercapitalization

Avatar 37a3bd7bc7328f0ead2c0f6f635dddf60615e676e6b4ddf964144012e529de45 asked

Hi I am Rohith. I am CA student. Compare Overcapitalization & undercapitalization

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Avatar 37a3bd7bc7328f0ead2c0f6f635dddf60615e676e6b4ddf964144012e529de45 answered

**Difference between Over Capitalization and Under Capitalization of Company!** **Over Capitalization:** A company is said to be overcapitalized when the aggregate of the par value of its shares and debentures exceeds the true value of its fixed assets.In other words, over capitalisation takes place when the stock is watered or diluted. It is wrong to identify over capitalisation with excess of capital, for there is every possibility that an over capitalised concern may be confronted with problems of liquidity. The current indicator of over capitalisation is the earnings of the company. If the earnings are lower than the expected returns, it is overcapitalised. Overcapitalisation does not mean surplus of funds. It is quite possible that a company may have more funds and yet to have low earnings. Often, funds may be inadequate, and the earnings may also be relatively low. In both the situations there is over capitalisation. Over capitalisation may take place due to – exorbitant promotion expenses, inflation, shortage of capital, inadequate provision of depreciation, high corporation tax, liberalised dividend policy etc. Over capitalisation shows negative impact on the company, owners, consumers and society. **Under capitalization:** Under capitalisation is just the reverse of over capitalisation, a company is said to be under capitalised when its actual capitalisation is lower than its proper capitalisation as warranted by its earning capacity. This happens in case of well established companies, which have insufficient capital but, large secret reserves in the form of considerable appreciation in the values of fixed assets not brought into books. In case of such companies, the dividend rate will be high and the market value of their shares will be higher than the value of shares of other similar companies. The state of under capitalisation of a company can easily be ascertained by comparing of a book value of equity shares of the company with their real value. In case real value is more than the book value, the company is said to be under capitalised. Under capitalisation may take place due to – under estimation of initial earnings, under estimation of funds, conservative dividend policy, windfall gains etc. Under-capitalisation has some evil consequences like creation of power competition, labour unrest, consumer dissatisfaction, possibility of manipulating share value etc..

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Avatar 37a3bd7bc7328f0ead2c0f6f635dddf60615e676e6b4ddf964144012e529de45 answered

**Compare Over capitalization & under capitalization..** - Over capitalization is a state where earnings are not sufficient to justify the fair return on the amount of share capital which has been issued by the company whereas under capitalization is a state where the capital which is owned by the business is much less than the borrowed capital. - Over capitalization happens when the actual profits of a company are not enough or sufficient to pay interest to the creditors whereas under capitalization happens due to over-trading and when the company earn high profits as compared to other industry. - Over capitalization shows the rate of return as declining entity whereas undercapitalization shows the rate of return as increasing entity.

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