Under-Capitalisation: Causes, Effects and Remedies

After reading this article you will learn about the Under-Capitalisation:- 1. Meaning of Under-Capitalisation 2. Causes of Under-Capitalisation 3. Effects 4. Remedies.

Meaning of Under-Capitalisation:

In the words of Gersrtenberg, “A company may be under-capitalised when the rate of profits it is making on the total capital is exceptionally high in relation to the return enjoyed by similarly situated companies in the same industry, or when it has too little capital with which to conduct its business”.

In simple words, we can say that under-capitalisation is the reverse phenomenon of over-capitalisation, and occurs when a company’s actual capitalisation is lower than its proper capitalisation as warranted by its earning capacity. The term under-capitalisation should never be considered synonymous with inadequate capital.

The real value of an under-capitalised company is more than its book value. The profits are higher than warranted by the book value of its assets. Such a company can pay a higher rate of dividend and the market value of its shares is much higher than its face value.

Causes of Under-Capitalisation:

Following are the important causes of under-capitalisation in a company:

1. Under-Estimation of Capital Requirements:

If the future capital requirements are under­estimated by the promoters, the inadequacy of capital is experienced at a later stage. The company may arrange cheaper debt at lower rate of interest at that stage resulting in increased earnings per share. This leads the company to a situation of under-capitalisation.

2. Under-Estimation of Future Earnings:

While preparing the financial plan, if the future earnings of the company are under estimated and the actual earnings turn out to be higher than the estimated figure, the company may find itself in a condition of under-capitalisation.

3. Promotion during Depression:

Companies promoted during a period of depression often experience under-capitalisation when inflation sets in because of a sudden rise in their earnings.

4. Conservative Dividend Policy:

If the management of a particular company adopts an orthodox dividend policy, i.e. where it follows a cautious policy regarding the distribution of dividend and keeps a major part of its earnings for re-investment purpose, it results into higher earnings and conditions of under-capitalisation.

5. Very Efficient Management:

In companies, where the management is very efficient, the rate of return may be quite high as compared to other companies in the same industry, and such a high rate of return may eventually lead towards under-capitalisation.

6. Desire of Control and Trading on Equity:

In many companies, the promoter desires to retain control over the company and raises lesser amount of share capital. However, later on when the funds are required they resort to trading on equity. This raising of funds at a lower rate of interest than the earnings of the company eventually leads to under-capitalisation.

Effects of Under-Capitalisation:

Like over-capitalisation, under-capitalisation also has many evil effects on the company and its owners as well as the society as a whole.

The main disadvantages of under-capitalisation are as below:

1. Under-capitalisation induces management to change and manipulate the market value of shares and expanding the business.

2. As a consequence of under-capitalisation, earnings per share increase and so do the dividend per share, which is turn, increases the marketability of shares.

3. When the employees find that the company is earning high profits they press for higher wages and as a result, a tiff between the workers and employers takes place giving rise to labour unrest.

4. As a consequence of under-capitalisation, the companies earn huge profits and as a result, the burden of tax is great. The government introduces higher rate of taxation which is a financial burden on the companies.

5. Higher profits earned by the companies give a psychological feeling to the customers that they are being over-charged and hence they develop grouse towards that company.

6. Higher earnings may encourage competitors to enter into a cut-throat competition amongst themselves.

7. A situation of over-trading by the company may arise as a result of under-capitalisation, where the company does excessive business than what its finances can allow.

8. As a result of over-trading, creditors will not be paid timely and the company will effect its creditworthiness adversely.

9. Under-capitalisation eventually leads to over-capitalisation because of excessive profits, huge retained earnings and long-term debt financing.

Remedies for Under-Capitalisation:

Under-capitalisation can be corrected by taking any of the following remedial measures:

1. Fresh Issue of Shares:

If under-capitalisation is due to inadequacy of capital, then it can be corrected by the issue of fresh shares, the company may also redeem its long-term debt by the issue of fresh share capital.

2. Issue of Bonus Shares:

The company may issue bonus shares by capitalising its accumulated earnings. This is the most commonly used and effective method of correcting under-capitalisation. It reduces earnings per share after the bonus issue.

3. Increasing the Par Value of Shares:

The company may revalue its assets and increase their values. In lieu, thereof, the par value of shares may also be increased. This will result into reduction of earnings per rupee of share value but the amount of dividend per share will remain same.

4. Splitting Stock. Another effective method of correcting under-capitalisation is to split up the existing stock into larger number of shares reducing the value of each share. It neither affects the total earnings of the company nor the total amount of capital of the company but still dividend per share shall reduce.