Capitalization Concepts and Theories

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.

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.