Types of Capitalization in Financial Management

The word capitalization, or valuation of the capital, includes debt and capital stock. From another point of view, it is a term mostly referred to as the sum of the outstanding stocks and funded obligations which are wholly fictitious values.

Capitalization, it is the sum of a corporation’s stock, long term debt, and retained earnings. This ‘valuation’ concept places emphasis on the amount of capital. Initially, it is used in the sense of ‘valuation’ and ‘amount’, but qualitative connotation occurs at the same time with the quantitative expression. The term capitalization is now considered synonymous to capital structure or financial plan.

Analysis of capitalization involves three aspects:

  • Amount of capital
  • Form or composition of capital
  • Changes in the capitalization

Again there are three types of capitalization namely:

  • Over capitalization, 
  • Under capitalization
  • Fair capitalization. 

Among the above three, over-capitalization is of practical interest.

Over Capitalization:

Many people miss understand that over-capitalization is an abundance of capital, whereas under-capitalization is a shortage of capital. So in-detail discussion is essential to have clarity. When we say an organization is over-capitalized that means its earning capacity does not justify the amount of capitalization. It has nothing to do with redundancy of the capital, but there is a probability that over-capitalized concern will be short of capital. Reasons can be explained by applying certain objective tests. These tests compare between the different values of the equity shares. When we talk about over-capitalization, we always have the interest of equity holders in mind.

There are various standards of valuing a corporation, such as Par value, Market value, Book value, Real value. 

When Book Value = Real Value, it is Fair capitalization.

When Book Value > Real Value, it is Over capitalization.

When Book Value < Real Value, it is under capitalization.

Causes of over-capitalization:

  1. Promotion with inflated asset
  2. The incurring high promotion expenses 
  3. Inflationary conditions
  4. Shortage of capital
  5. Defective depreciation policy
  6. Following liberal dividend policy
  7. Excessive taxation 

Effects of over capitalization:

Over-capitalization affects the shareholders, the company, and the society as a whole. Confidence of Investors is hindered in an over-capitalized company, on the account of its reduced earning capacity and the market price of the shares. Credit standing of a corporation will be relatively low.

Consequently, the firm may be forced to take huge debts and bear the loss of its goodwill in a subsequent reorganization. Part from depreciating capital, income will be uncertain and irregular and holdings have little value as a collateral security. Burden of over capitalization on shareholders is double.

An over-capitalized organization tries to increase the prices and decrease the quality of products, as a result the company may liquidate. In this case creditors and laborers get affected. Thus mis ­use and wastage of the society resources.

Corrections for over-capitalization:

Over capitalization can be corrected by following the steps below:

  1. Reorganization of the company by selling shares at a discounted rate.
  2. Issue less interested debentures on premium, in place of old debentures.
  3. Redeem preference shares for high dividend
  4. Reduce the face value of shares.

Under-Capitalization:

Normally, under-capitalization is considered equivalent to the inadequacy of capital, but actually it should be the reverse of over-capitalization, that means the real value of the corporation is greater than book value.

Causes of under-capitalization:

  1. Underestimating of earnings
  2. Unpredictable rise in earnings
  3. Following conservative dividend policy
  4. Maintaining high efficiency 

Effects of under-capitalization:

The following are the effects of under-capitalization:

  1. Fluctuations in the market value of shares.
  2. Encourage management to maintain secret reserves.
  3. Employees demand high shares with the increased prosperity of the company.

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