Effects of Overcapitalization
- On Shareholders- The over capitalized companies have following disadvantages to shareholders:
- Since the profitability decreases, the rate of earning of shareholders also decreases.
- The market price of shares goes down because of low profitability.
- The profitability going down has an effect on the shareholders. Their earnings become uncertain.
- With the decline in goodwill of the company, share prices decline. As a result shares cannot be marketed in capital market.
- On Company-
- Because of low profitability, reputation of company is lowered.
- The company’s shares cannot be easily marketed.
- With the decline of earnings of company, goodwill of the company declines and the result is fresh borrowings are difficult to be made because of loss of credibility.
- In order to retain the company’s image, the company indulges in malpractices like manipulation of accounts to show high earnings.
- The company cuts down it’s expenditure on maintainance, replacement of assets, adequate depreciation, etc.
- On Public- An overcapitalized company has got many adverse effects on the public:
- In order to cover up their earning capacity, the management indulges in tactics like increase in prices or decrease in quality.
- Return on capital employed is low. This gives an impression to the public that their financial resources are not utilized properly.
- Low earnings of the company affects the credibility of the company as the company is not able to pay it’s creditors on time.
- It also has an effect on working conditions and payment of wages and salaries also lessen.
An undercapitalized company is one which incurs exceptionally high profits as compared to industry. An undercapitalized company situation arises when the estimated earnings are very low as compared to actual profits. This gives rise to additional funds, additional profits, high goodwill, high earnings and thus the return on capital shows an increasing trend. The causes can be-
- Low promotion costs
- Purchase of assets at deflated rates
- Conservative dividend policy
- Floatation of company in depression stage
- High efficiency of directors
- Adequate provision of depreciation
- Large secret reserves are maintained.