Capitalization Concepts and Theories
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Questions and Answers

What is the primary reason for over-capitalisation during an inflationary period?

  • Increased cash flow due to sales
  • Reduction in operational expenses
  • Higher interest rates on loans
  • Buying lower value assets at higher prices (correct)
  • Which of the following is NOT a cause of over-trading?

  • Sufficient cash resources for operations (correct)
  • Inflation and rising prices
  • High incidence of taxation
  • Increased lock-up of funds in stocks
  • What is one of the signs of over-trading?

  • Decline in the rate of gross profits (correct)
  • Increase in sales efficiency
  • Decrease in bank borrowings
  • Increase in working capital ratio
  • Which consequence of over-trading most directly affects employee wages?

    <p>Decline in sales</p> Signup and view all the answers

    What is the remedy for preventing over-trading?

    <p>Cutting down on business and spending</p> Signup and view all the answers

    Under-trading primarily results from which of the following?

    <p>Idle funds not being utilized</p> Signup and view all the answers

    Which of the following best describes the financial state in under-trading?

    <p>Low return on capital employed</p> Signup and view all the answers

    What is a consequence of over-trading related to creditworthiness?

    <p>Difficulty in raising funds because of poor creditworthiness</p> Signup and view all the answers

    Which of the following components is NOT part of the capitalization according to Gilbert Harold?

    <p>Short-term Debt</p> Signup and view all the answers

    Under what situation is capitalization considered necessary for a company?

    <p>At the time of re-organisation of capital</p> Signup and view all the answers

    What does the Cost Theory in capitalization focus on?

    <p>Adding up the cost of fixed assets and promotional expenses</p> Signup and view all the answers

    If Sunny Enterprises Ltd. has annual earnings of Rs. 3,00,000 and the fair rate of return is 12%, what is the amount of capitalization?

    <p>Rs. 2,500,000</p> Signup and view all the answers

    Which of the following best describes over-capitalisation?

    <p>Having shares and debentures exceed current asset value</p> Signup and view all the answers

    What could lead to over-capitalisation in a company?

    <p>Acquiring fictitious assets at inflated prices</p> Signup and view all the answers

    Which condition is NOT typically associated with the Modern Concept of Capitalisation?

    <p>Acquisition during recession</p> Signup and view all the answers

    According to the Earnings Theory, what does capitalisation depend on?

    <p>Estimated earnings and expected return</p> Signup and view all the answers

    Study Notes

    Capitalization

    • Capitalization can refer to several concepts:

      • Total par value: Sum of all shares and debentures outstanding at a specific time.
      • Total par value + Long-term obligations: Includes all securities plus the value of other long-term debts.
      • Total capital and liabilities: Total value of capital stock, bonds, reserves, surplus, short-term debt, and creditors.
    • Modern Concept of Capitalization applies during specific periods:

      • Formation or Incorporation of a company.
      • Expansion of an existing company.
      • Merging or Absorbing of companies.
      • Reorganizing the capital structure of a company.

    Need for Capitalization

    • Capitalization is necessary to ensure the sustainable operation and growth of a company.

    Theories of Capitalization

    • Cost Theory: Capitalization is calculated by summing up the cost of fixed assets (e.g., buildings, machinery), working capital, and establishment expenses.
    • Earnings Theory: Capitalization depends on estimated earnings and the expected return on investment. The value of capitalization equals the capitalized value of future earnings.

    Example of Earnings Theory Calculation

    • If Sunny Enterprises Ltd. estimates annual earnings of Rs. 3,00,000 and the fair return rate is 12% (or 15%), the capitalization, or the value of the company, would be Rs. 25,00,000 (or Rs. 20,00,000).

    Over-Capitalization

    • Occurs when the value of shares, debentures, public deposits, and loans exceed the current value of assets.
    • Causes:
      • Fictitious assets at inflated prices: Goodwill acquired at an unreasonable cost can contribute to over-capitalization.
      • Acquiring assets during inflation: High prices during inflation can lead to overvaluing assets.
      • Lack of proper depreciation: Inadequate depreciation policies can increase the perceived value of assets, resulting in over-capitalization.
      • Over-issue of capital: Raising more capital than needed during a company's formation can lead to over-capitalization.
      • Expansion during inflation: Extensive spending during inflationary periods can overinflate the capital structure.
      • Acquiring assets at inflated prices: Purchasing assets at prices higher than their actual value can lead to over-capitalization.

    Over-Trading

    • Over-trading occurs when a company undertakes a larger volume of business than its finances can support.
    • It's related to the company's cash position and can happen when operations expand beyond the available cash resources.
    • Causes:
      • Rising Prices and Inflation: High prices increase the need for capital, putting pressure on cash flow.
      • High Taxation: High tax burdens reduce cash available for investment.
      • Increased Inventory Levels: Holding large amounts of inventory ties up cash, potentially leading to over-trading.
      • Over-Expansion: Expanding too rapidly without sufficient financial planning can result in over-trading.

    Signs of Over-Trading

    • Increased borrowing: A company seeking more credit than usual.
    • Growing Inventory Levels: An increase in raw materials and finished goods.
    • Fixed assets purchased with short-term funds: Using short-term loans to fund long-term assets.
    • Decreasing working capital ratio: Working capital is insufficient to cover the scale of operations.
    • Reduced profit margins: Lower profitability due to cost pressures and inefficient management.
    • Low current ratio and high turnover ratios: Indicates a company is relying heavily on debt and its assets are not managed effectively.

    Consequences of Over-Trading

    • Inability to pay wages or taxes.
    • Decreased sales and expensive purchases.
    • Difficulty in raising funds due to poor creditworthiness.
    • Challenges with debtors and creditors.
    • Delayed maintenance and repairs, leading to inefficiency.
    • Outdated machinery replaced with older equipment due to financial constraints.

    Remedies for Over-Trading

    • Reduce business or secure additional funds: Scale back operations or find sources of capital to address the cash shortfall.
    • Proactive prevention: Take steps to avoid over-trading by carefully planning expansion and managing finances.

    Under-Trading

    • The opposite of over-trading, where there is excessive investment in current assets (e.g., cash, inventory) and a smaller amount of current liabilities.
    • Essentially, the company is under-utilizing its funds.

    Consequences of Under-Trading

    • Lower profits: Reduced returns due to inefficiently allocated funds.
    • Lower return on capital: A less attractive investment for shareholders and stakeholders.

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    Description

    Explore the various definitions and theories surrounding capitalization, including total par value, long-term obligations, and the need for capital in a company's sustainable operation. This quiz delves into the modern concepts of capitalization and the significance of different theories like Cost and Earnings Theory.

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