Over-Capitalisation: Meaning,

Effects and Remedies

 Meaning of Over-Capitalisation:

Over-capitalisation refers to that state of

affairs where earnings of a company do not
justify the amount of capital invested in its
business.
 According to Gerstenberg, A company is
over-capitalised when its earnings are not
large enough to yield a fair return on the
amount of stock and bonds that have been
issued, or when the amount of securities
outstanding exceeds the current value of the
assets.
 In the words of Bonneville, Deway and Kelly,
When a business is unable to earn fair rate on its
outstanding securities, it is over-capitalised.
Simply stated, over-capitalisation means more
capital than actually required, and therefore, in a
over capitalised concern, the invested funds are
not properly used. It is, therefore, quite clear that
over-capitalisation may be explained in terms of
earnings as well as cost of assets.
 In terms of earnings, over-capitalisation arises when the
earnings of the company are not sufficient to give a normal
return on capital employed by it. Let us take an example.
Suppose, a company earns Rs,5,00,000 and the normal rate
of return expected is 10% then capitalisation at Rs.
50,00,000 would be (5,00,000 100/10) = (Rs. 50,00,000) a
fairly capitalised situation. But suppose, the capital
employed by this company is Rs. 60,00,000.
Then we will say that the company is over-capitalised to the
extent of Rs. 10,00,000. The new rate of earnings in this
company now would be (5,00,000/60,00,000 100) = Rs.
8%
 hus, we see that as a result of over-capitalisation,
the rate of earnings has dropped from 10% to 8%.
Therefore, we can say that the test of over
capitalisation is the lower rate of return on capital
over a long-term.
On the other hand, over-capitalisation may occur
when the amount of shares debentures, public
deposits and loans exceed the current value of
the assets.
 This may be due to:
(1) Acquiring of fictitious assets like goodwill at high
prices.
(2) Acquiring assets during inflationary period.
(3) Showing assets at increased value due to lack of
proper depreciation policy.
Thus, we can summarise the entire concept of over-
capitalisation in the words of Harold Gillbert as: When a
company has consistently been unable to earn the
prevailing rate of return on its outstanding securities
(considering the earnings of similar companies in the
same industry and the degree of risk involved) it is said to
be over-capitalised.
 Illustration 2:
A firm earns Rs. 4,80,000 annually after paying
all expenses and interest. The total amount of
capital employed by the firm is Rs. 60,00,000
and the fair rate of return expected by
investors is 12%. Is the firm over-capitalised
and, if so, by how much?
 Solution:
6000000 x 12/100 =720000 (480000)
=240000
= 8%
 Over-Capitalisation and Excess of
Capital:
It may be noted that over-capitalisation is not exactly
the same as excess of capital. Abundance of capital
may be one of the reasons of over-capitalisation but it
is not the only reason. In fact, in actual practice, many
over-capitalised companies have been found to be
short of funds.
Over-capitalisation arises when the existing capital of a
firm is not effectively utilised with the result that there
is a fall in the earning capacity of the company. Thus,
the main sign of over-capitalisation is fall in the rate of
dividend and market value of shares of the company in
the long-run.