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?

Decline in sales Signup and view all the answers

What is the remedy for preventing over-trading?

Cutting down on business and spending Signup and view all the answers

Under-trading primarily results from which of the following?

Idle funds not being utilized Signup and view all the answers

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

Low return on capital employed Signup and view all the answers

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

Difficulty in raising funds because of poor creditworthiness Signup and view all the answers

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

Short-term Debt Signup and view all the answers

Under what situation is capitalization considered necessary for a company?

At the time of re-organisation of capital Signup and view all the answers

What does the Cost Theory in capitalization focus on?

Adding up the cost of fixed assets and promotional expenses 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?

Rs. 2,500,000 Signup and view all the answers

Which of the following best describes over-capitalisation?

Having shares and debentures exceed current asset value Signup and view all the answers

What could lead to over-capitalisation in a company?

Acquiring fictitious assets at inflated prices Signup and view all the answers

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

Acquisition during recession Signup and view all the answers

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

Estimated earnings and expected return 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.