Causes of overcapitalization and how to overcome it in your company

Overcapitalization is “when the company’s securities are issued in excess of their capitalized earning power.” Overcapitalization demoralizes equity shareholders who have invested their savings in buying stocks. They don’t get dividends because the company doesn’t make enough profit to declare them as dividends.

This state can also imply a shortage of capital. It is a capital shortage because the sum of the face value of the outstanding stocks and bonds exceeds the value of the fixed assets. The market value of equity stocks eventually declines.

Nine causes of overcapitalization

1.) Excessive issuance of shares: Due to poor planning, a company issues more shares and bonds than it should. This results in low earnings.

2.) Acquisition of assets at inflated prices: If assets are bought at inflated prices, the result is a low book value. The real value of assets is low, resulting in low earnings per share.

3.) Boom Period: When a company is formed during the boom period, it experiences low profits after the boom period is over.

4.) Overestimated earnings: During the promotion stage, promoters and directors may overestimate the earnings of the company, thus obtaining more capital than required. This excess capital leads to lower profits.

5.) Adoption of the Liberal Dividend Policy: If it is adopted, it causes low profits in the long term. It results in a low book value compared to the real value.

6.) Lack of Reserves: When a company is not making enough provisions for reserves, an overcapitalization occurs. This is especially the case if you distribute the total earnings as dividends to shareholders.

7.) Large Promotion and Organization Expenses: When the expenses incurred for the promotion of the company, such as the issuance and subscription of shares, the remuneration of the promoter are very high compared to their benefits for the company, this translates into a overcapitalization.

8.) Shortage of capital: If a company does not have enough capital, it is forced to raise additional capital through loans at high interest rates, resulting in low profits.

9.) Tax policy: Overcapitalization occurs when the policy adopted by the government is not fair. A small amount of profit is left to cover depreciation and dividends. Your earning capacity is reduced as a result of high taxes.

Seven ways to overcome compounding

1.) The efficiency and productivity of the human force and the resources of other companies must be increased. Their waste should be avoided. This results in increased profits.

2.) The company should reinvest its profits. This stabilizes the company’s earnings in difficult times.

3.) There must be a reduction of the debts financed through the exchange of debentures and bonds in order to equalize the book value and the real value.

4.) Interest rates on bonds must be lowered to ensure sufficient profit for the business.

5.) If the preferred shares have a high dividend, then they should be redeemed.

6.) There should be a reduction in the par value of the shares.

7.) The number of shares should be reduced.