CAPITALIZATION, MEANING OF CAPITALIZATION

Capitalization, meaning of capitalization

Financial planning and decision play a major role in the field of business finance which consists of the major area of business finance such as, capitalization, financial structure, capital structure, leverage, and financial forecasting.

Read also: MEANING OF BUSINESS FINANCE

Financial planning includes the following important parts: Estimating the amount of capital to be raised; determining the form and proportionate amount of securities and formulating policies to manage the financial plan. Having looked at the various sources of finance for a business, we shall discuss whether such a business is overcapitalized, undercapitalized, and watered capitalized.

Objectives by the end of this session, you should be able to:

(a) define capital

(b) explain the types of capital

Now read on …

Table of Contents

6.1 MEANING OF CAPITAL

The term capital refers to the total investment of the company in terms of money and assets. It is also called as total wealth of the company. When the company is going to invest a large amount of finance into the business, it is called capital.

Capital is the initial and integral part of the new and existing business concern. The capital requirements of the business concern may be classified into two categories: fixed capital and working capital.

6.1.1 Fixed Capital

Fixed capital is the capital, which is needed for meeting the permanent or long-term purpose of the business concern.

Fixed capital is required mainly for the purpose of meeting the capital expenditure of the business concern and it is used over a long period.

It is the amount invested in various fixed or permanent assets, which are necessary for a business concern. According to the definition of Hoagland, “Fixed capital is comparatively easily defined to include land, building, machinery and other assets having a relatively permanent existence”.

The character of Fixed Capital

Fixed capital is used to acquire the tangible non-current assets of the business concern.
Fixed capital meets the capital expenditure of the business concern.
Fixed capital normally consists of a long period.
Fixed capital expenditure is of nonrecurring nature.
Fixed capital can be raised only with the help of long-term sources of finance.

6.1.2 Working Capital

Working capital is the capital that is needed to meet the day-to-day transaction of the business concern.

It may cross be working capital and net working capital. Normally working capital consists of various compositions of current assets such as inventories, bills, receivable, debtors, cash, and bank balance, and prepaid expenses.

We know you remember this in your first year when you took the Foundation of Accounting course. You now understand the relevance of Accounting right. According to the definition of Bonneville, “any acquisition of funds which increases the current assets increase the Working Capital also for they are one and the same”.

Working capital is needed to meet the following purpose:

Purchase of raw material
Payment of wages to workers
Payment of day-to-day expenses
Maintenance expenditure etc.

6.2 MEANING OF CAPITALIZATION

Capitalization is one of the most important parts of financial decisions, which is related to the total amount of capital employed in the business concern.

Understanding the concept of capitalization leads to solving many problems in the field of business finance. Because there is confusion among the capital, capitalization, and capital structure.

Capitalization refers to the process of determining the quantum of funds that a firm needs to run its business.

Capitalization is only the no-par value of share capital and debenture and it does not include reserve and surplus.

According to Guthman and Dougall, “capitalization is the sum of the no-par value of shares and bonds outstanding”.

Capitalization is the balance sheet value of shares and bonds outstands”. From the meaning so far, we can say capitalization relates to the long-term funds of the business.

This long-term finance relates to equity finance and debt finance of the business. Capitalization may be classified into the following three important types based on its nature:

Over Capitalization
Under Capitalization
Water Capitalization

6.2.1 Over Capitalization

Over capitalization refers to the company which possesses an excess of capital in relation to its activity level and requirements. In simple means, overcapitalization is more capital than actually required and the funds are not properly used. According to Bonneville, Dewey, and Kelly, overcapitalization means, “when a business is unable to earn fair rate on its outstanding securities”.

Example A company is earning a sum of GHS50,000 and the rate of return expected is 10%. This company will be said to be properly capitalized. Suppose the capital investment of the company is GHS60,000, it will be overcapitalization to the extent of GHS100,000. The new rate of earning would be 50,000/60,000×100=8.33%. When the company has over capitalization, the rate of earnings will be reduced from 10% to 8.33%.

6.2.1.1 Causes of Over Capitalization

Over capitalization arise due to the following important causes:

Over the issue of capital by the company.
Borrowing a large amount of capital at a higher rate of interest.
Providing inadequate depreciation to the non-current assets.
Excessive payment for the acquisition of goodwill.
High rate of taxation.
Underestimation of the capitalization rate.

6.2.1.2 Effects of Over Capitalization

Over capitalization leads to the following important effects:

Reduce the rate of earning capacity of the shares.
Difficulties in obtaining the necessary capital for the business concern.
It leads to falling in the market price of the shares.
It creates problems on re-organization.
It leads to under or misutilisation of available resources.

6.2.1.3 Remedies for Over Capitalization

Over capitalization can be reduced with the help of effective management and systematic design of the capital structure. The following are the major steps to reduce overcapitalization.

Efficient management can reduce overcapitalization.
Redemption of preference share capital consists of the high rate of dividend. • Reorganization of equity share capital.
Reduction of debt capital.

6.2.2 Under Capitalization

Undercapitalization is the opposite concept of overcapitalization and it will occur when the company’s actual capitalization is lower than the capitalization as warranted by its earning capacity.

Undercapitalization is not the so-called inadequate capital. Undercapitalization was defined by Gerstenberg, as the rate at which a company’s profit is exceptionally high in the same industry.

Hoagland defined undercapitalization as “an excess of true assets value over the aggregate of stocks/shares and bonds outstanding”.

6.2.2.1 Causes of Under Capitalization

Undercapitalization arises due to the following important causes:

Underestimation of capital requirements.
Underestimation of initial and future earnings.
Maintaining high standards of efficiency.
Conservative dividend policy.
The desire for control and trading on equity.

6.2.2.2 Effects of Under Capitalization

Capitalization leads to certain effects on the company and its shareholders.

It leads to manipulating the market value of shares.
It increases the marketability of the shares.
It may lead to more government control and higher taxation.
Consumers feel that they are exploited by the company.
It leads to high competition.

6.2.2.3 Remedies of Under Capitalization

Under Capitalization may be corrected by taking the following remedial measures:

Undercapitalization can be compensated with the help of fresh issues of shares. • Increasing the no-par value of a share may help to reduce undercapitalization.
Undercapitalization may be corrected by the issue of bonus shares to the existing shareholders.
Reducing the dividend per share by way of splitting up of shares.

6.2.3 Watered Capitalization

If the capital of the company is not mentioned by assets of equivalent value, it is called watered capital.

In simple words, watered capital means that the realizable value of assets of the company is less than its book value. According to Hoagland’s definition, “A capital is said to be watered when its true value is less than its book value.”

6.2.3.1 Causes of Watered Capital

Generally watered capital arises at the time of incorporation of a company but it also arises during the lifetime of the business.

The following are the main causes of watered capital:

Acquiring the assets of the company at a high price.
Adopting ineffective depreciation policy.
Worthless intangible assets are purchased at a higher price.

SUMMARY

In this session, we defined capitalization as the process of determining the quantum of funds that a firm needs to run its business. This may lead to a firm been overcapitalized, undercapitalized, or watered.

The causes and effects of these types of capitalization have been explained in this session. When going for funding, it is imperative to understand the needs of your business and ensure that you get the funding that is appropriate for the smooth operations of the business.

By: Eric Adjei

Co-Author

A professional with six (7) years’ experience in finance and accounting. Demonstrating expertise in accounting procedures, computerized accounting system management and financial operations. Financially astute with excellent analytical, problem solving, management, people supervision, organizational, business administration, operation and commercial management and teaching skills.

CAPITALIZATION, MEANING OF CAPITALIZATION