Companies require funding to operate their businesses. This funding can be internally generated through their business operations or can be externally generated through forms of equity and debt. Balancing the external funding generated with the needs of the business is important to run business operations smoothly. Funding should also be commensurate with the scale and capacity of the business.
This article looks at meaning of and differences between two financial situations caused due to incorrect planning of funding requirements – overcapitalization and undercapitalization.
Definitions and meanings
Overcapitalization
Overcapitalization is a financial situation in which the value of equity and debt issued by a company exceeds the value or worth of its assets, specifically its fixed assets. It is essentially a state in which a company is over-funded.
Overcapitalization is primarily an indication of reduced earning capacity of the company. The impact of overcapitalization for a company is that it is likely to be burdened with high interest obligations which it may not be able to fulfill. In fact, severe overcapitalization can lead to spiraling condition of further reduced earnings, reduction in share value and loss of investor confidence, if remedial steps are not taken.
An example of overcapitalization:
The average return on capital employed for the pharmaceutical sector is 10%. Within this sector, an individual pharmaceutical company M/s XYZ Inc generates annual profits of $100,000 with a total funding of $1,200,000. If the returns of XYZ Inc are to be compared with its sector average, it should have a capital funding of $1,000,000 to justify its returns (100,000/10%). It thus can be considered to be overcapitalized to the extent of $200,000.
Overcapitalization can be caused due to several reasons including:
- Incorrect estimation of funding needs at beginning or expansion stages of the business
- Lower return generating capacity of the business due to several factors
The benefit of overcapitalization on the other hand, is that the company has excess funds which it can apply productively in its business including for any acquisitions or expansions.
Undercapitalization
Undercapitalization is when a company faces a situation of under-funding. An undercapitalized company does not have sufficient funds to meet the cash flow demands of its business operations.
Undercapitalization can occur when a company is not performing at a level that generates sufficient cash flows or is unable to raise sufficient capital through long term debt or equity route.
Undercapitalized companies can face issues with growth and expansion as they suffer from lack of funding. These companies also find it difficult to pay its creditors and other dues which if severe, can eventually lead the company to a situation of bankruptcy if remedial action is not taken.
Difference between overcapitalization and undercapitalization:
The key points of difference between overcapitalization and undercapitalization have been detailed below:
1. Meaning
Overcapitalization is a financial condition of a company in which its total debt and equity outstanding significantly exceeds the value of its assets.
Undercapitalization is a financial condition of a company in which the value of its capital is significantly lower than the quantum of its assets, specifically fixed assets.
2. Indicates
Overcapitalization indicates a situation of over-funding i.e.: the company has raised excessive funds as compared to its current requirements.
Undercapitalization indicates a situation of under-funding i.e.: the company does not have enough funds/cash flow to meet the current needs of its business operations.
3. Causes
Overcapitalization can be caused by several reasons including over-estimation of funding requirements at the time of raising capital, low return generation by the business etc.
Undercapitalization can be caused by several reasons including– incorrect estimation of initial funding requirements, inability to raise sufficient funds in the form of capital and long-term debt, funding through expensive short-term debt etc.
4. Negative impact
The primary negative impact of overcapitalization is that the company incurs heavy financing cost obligations which it may not be able to fulfill. In severe cases of overcapitalization this can result in continuous reduction of earnings leading to lost investor confidence and downward spiral of share prices.
The primary negative impact of undercapitalization is loss of growth due to lack of funds to support expansion. Inability pay creditors by an undercapitalized company can eventually lead a company to bankruptcy in severe cases.
5. Advantages
The key benefit of overcapitalization is that the company has sufficient funds to undertake expansions of its operations. This can be a boost to the growth rate of the company.
The key benefit of undercapitalization is that the company can earn higher rate of return on its capital.
6. Remedy
Overcapitalization in a company is often tougher to remedy than undercapitalization. The remedies for overcapitalization include increasing efficiency of the business to curb expenditure, redemption of shares, reduction in long term debt etc.
Undercapitalization can be corrected by exploring routes of raising additional funds – this can primarily be done through issue of additional shares and raising of low-cost long-term debt.
7. Typically faced by
Overcapitalization can be faced by any company that has done poor funding and financial planning and whose management is unable to manage the business costs efficiently.
Undercapitalization is typically faced by smaller less established companies who face difficulties in obtaining adequate funding to run their business operations.
Conclusion – overcapitalization vs undercapitalization:
While both overcapitalization and undercapitalization have their own individual benefits and drawbacks for a business, they are both not ideal financial positions for a business entity. Adequate capitalization is what companies should strive to achieve. A situation in which the company earns enough money to fund its business operations as well service its financing obligations is indicative of adequate capitalization.Such a situation is ideal rather than a situation of overcapitalization or undercapitalization.
