Overcapitalization occurs when a business acquires more capital investment than needed. It may require substantial capital investment for working capital or capital investment projects. However, inaccurate forecasting and other reasons may lead a business to excessive capital.
Overcapitalization can have negative impacts on the working capital management of a business. It also affects the profitability and sustainability of the business in the long term.
Let us discuss what is overcapitalization, its causes, and its solutions.
What is Overcapitalization?
Overcapitalization refers to a situation where a company issues more debt and equity capital than its net assets. It means a business has funded more capital than it acquired assets that result in overcapitalization.
Overcapitalization can occur due to several reasons. For instance, a sudden drop in the value of net assets may show an overcapitalized business. Similarly, if a company has issued a large number of new shares (more than it needed), it would result in overcapitalization.
For a business having overcapitalization, its market value would fall against its capital value. The business would need to make more payments for dividends as well as interest payments on debt.
Overcapitalization may not be bad for all companies. However, in many cases, it results in the under-utilization of assets owned by a business. A business would rely on the borrowed capital more than its retained earnings that can affect the return on capital employed (ROCE) of the company.
How Does Overcapitalization affect Working Capital?
Overcapitalization in working capital can lead to distressing working capital management for any business. Cash flow is an integral part of working capital management. However, securing cash flow at a higher cost of capital can lower the profitability of the company.
Here are a few major effects of overcapitalization in working capital.
Increased Interest Cost
Overcapitalization in working capital is often a result of increased short-term borrowings. It means the interest cost for the company increases significantly.
An increased cost of interest would keep working capital management under constant pressure that will result in further borrowings.
Lower Profitability
Stressed working capital due to excessive borrowings and increased interest costs would mean lower profits for the company. The company will pay more on its debts than it would earn otherwise.
Under-Utilization of Assets
Overcapitalization in working capital is also an indication of the underutilization of assets by a business. Particularly, if a business does not properly utilize its cash reserves, it would lead to overcapitalization due to increased debt and equity capital funding.
Compromised Cash flow
Cash flow and working capital management are essential for the success of any business. Overcapitalization can lead to compromised cash flow of a business as more of it would go to interest or dividend payments than for the retained earnings.
Questionable Sustainability in the Long Run
Overcapitalization would also mean investors and creditors would demand a higher rate of return. In the long run, profits would get squeezed and the company will run out of liquidity as well. It can lead to questionable and compromised sustainability of a company in the long run.
What are the Indicators of Overcapitalization?
Overcapitalization cannot be identified equally for businesses of all sizes. For instance, an established business with large accumulated cash reserves will employ lower capital investment. Contrarily, a growing business would need increased borrowings inevitably.
We can see a few common indicators of an overcapitalized business generally.
Excess Cash Reserves
If a business has accumulated cash reserves from retained earnings, it shouldn’t be alarming. However, if the increase is sudden due to a debt or equity investment, it is a symptom of overcapitalization.
Increased Capital Investment
Intensive capital investment is a clear indicator of a business with overcapitalization. Businesses look for expansion with optimistic plans and acquire additional resources. If they acquire more resources than their net assets, that can soon turn into overcapitalization.
Large Dividends
One reason and an indicator of a business facing such a scenario is to pursue a large and liberal dividend policy. These businesses do not retain sufficient cash and issue large dividends instead.
Working Capital Issues
Another clear indicator of a business in such a situation is a troubled working capital. Often, a business overestimates its working capital requirements and arranges excessive capital investment.
What Causes Overcapitalization?
A business can end up with excessive capital funding due to several reasons. Mismanagement in working capital can also lead to the overcapitalization of a company.
Here are a few common causes of overcapitalization.
Excessive Capital Funding
Many businesses acquire excessive equity and debt capital fundings than necessary. It may be due to overestimation of capital project costs or overambitious planning. Either way, excessive capital funding is the main reason behind the overcapitalization of a business.
Overpriced Asset Acquisitions
One common cause for overcapitalization is acquiring assets at inflated prices. Overpriced assets would require higher capital investments that can lead to the overcapitalization of a company.
Overestimation of Earnings
Businesses aim to produce earnings at a targeted level in the future. They can fund projects with debt and equity capital in anticipation of future earnings. In some cases, overestimation of earnings would also result in excessive capital investment and overcapitalization.
Cashflow Management
If a business does not retain sufficient profits for internal growth, it will need to borrow more money. It means excessive dividend payments can also lead to the overcapitalization of a company in the long run.
Working Capital Management Issues
Inadequate working capital resources such as lower cash levels will lead to working capital management issues. Stressed cashflows in working capital would require excessive capital investments.
Example
Suppose a company ABC is an established business. It earned $ 300,000 with a 15% rate of return last year.
At 15%, the capital investment requirement for ABC can be calculated as:
Capital Requirement = Yearly Profit / Rate of Return
Capital Requirement = 300,000/15% = $ 2,000,000.
If ABC uses more capital than its fair capital requirement of $ 2 million, it will be considered an overcapitalized firm. Suppose it has invested $ 2.5 million in total capital investment.
Then,
Rate of Return = $ 300,000/2,500,000 = 12%
So, we can see the immediate impact of overcapitalization. The rate of return falls because ABC company produced the same profit using more capital resources than it required.
Pros and Cons of Overcapitalization
Overcapitalization has more negative impacts on a business in the long run than positives. However, if used properly, such situations can offer a few benefits as well.
Pros Explained
- Sufficient Resources: A company needs to fully utilize its capital investment resources in these situations. Once they acquire excessive capital, it’s time to pursue NPV projects that bring value to the company.
- Room for Expansion: Excessive capital investment also means if the company plans for expansion, it can pursue these plans without looking for additional resources.
Cons Explained
- Sustainability Issues: No business can afford to keep its resources as excessive cash in the long run. If a business does not utilize its capital investment, it will not generate sufficient profits in the long term.
- Increased Cost of Interest: Excessive capital investment also means increased borrowings. It leads to increased interest costs. For a business with already excessive resources, increased interest costs would lead to lower profits.
- Working Capital Issues: Often businesses overestimate their working capital needs and acquire more resources than needed. It means their working capital management does not work smoothly even after acquiring excessive resources.
Solutions for Overcapitalization
A business can take a more calculated approach to avoid overcapitalization problems. Although it depends on the business size and future plans of a company, here are a few key steps to avoid such situations.
Restructuring
Capital restructuring is one option for a company facing overcapitalization problems. A business can plan according to its expansion and growth needs.
Working Capital Management
Managing working capital and cashflows plays a crucial role in managing capital investment for any business. Thus, if a business can keep its cashflows and working capital smooth, it can avoid the problems of capitalization.
Revised Dividend Policy
Sometimes a business following a large-dividend policy may end up with low cash reserves. Eventually, it will look for external capital investment resources. Thus, a revised dividend policy can also work in favor of a business here.
Better Financial Forecasting
One of the major reasons a company falls into overcapitalization issues is the inaccuracy of its financial forecasting. It estimates significant growth and overestimates its capital requirements. Better financial forecasting can avoid such problems in the future.
Overcapitalization Vs Undercapitalization
Undercapitalization refers to a situation where a business does not have sufficient capital investment as compared to its needs. It means it is the opposite situation of overcapitalization.
Undercapitalized companies do not have sufficient cash reserve through retained earnings either. Due to their distressed financial situation, they cannot acquire external capital investment as well.
Both situations can be harmful to a business with varying effects. Undercapitalization may also need higher borrowing costs, compromised profits, and eventually questionable sustainability.