Capitalisation - OCR PDF

UNIT 5 Capitalis ation Gilbert Harold refers to capitalisation as any of the following concepts: (i) The total par value of all the securities -shares and debentures outstanding at a given time. (ii) The total par value of all the securities outstanding at a given time plus the valuation of all...

UNIT 5 Capitalis ation Gilbert Harold refers to capitalisation as any of the following concepts: (i) The total par value of all the securities -shares and debentures outstanding at a given time. (ii) The total par value of all the securities outstanding at a given time plus the valuation of all other long-term obligations. (iii) The total amount of capital and liabilities of corporation, i.e. amount of capital stock plus bonds.  (i) Share Capital (ii) Long-term Debt. (iii) Reserves and Surplus. (iv) Short-term Debt. (v) Creditors. Modern Concept of Capitalisation  i. At the time of promotion/incorporation of a company. ii. At the time of expansion of an existing company. iii. At the time of amalgamation and absorption of two or more companies. iv. At the time of re-organisation of capital of a company. Need of Capitalisation:  (i) The Cost Theory, and (ii) The Earnings Theory. Theories of Capitalisation: Cost theory The amount of capitalisation is arrived at by adding up the cost of fixed assets (like plants, machinery, building, etc.); working capital required for the continuous operations of the company; the cost of establishing the company and the promotional expenses.  The Earnings Theory. The capitalisation of a company depends upon its earnings and the expected fair rate of return on its capital invested. Thus, the value of capitalisation is equal to the capitalised value of the estimated earnings.  The estimated annual earnings of Sunny Enterprises Ltd. is Rs. 3,00,000. What will be the amount of capitalisation of the company if the fair rate of return earned by similar companies is (i) 12% and (ii) 15%. Solution:  On the other hand, over-capitalisation may occur when the amount of shares debentures, public deposits and loans exceed the current value of the assets. (1) Acquiring of fictitious assets like goodwill at high prices. (2) Acquiring assets during inflationary period. (3) Showing assets at increased value due to lack of proper depreciation policy.  1. Over-issue of capital. Sometimes, while floating a new company, the promoters over-estimate the financial requirements, and as a result, they raise more capital than what is actually needed, resulting in over-capitalisation. 2. Promotion, formation or development during inflation. If a company is to be floated during an inflationary period, or any development activity is carried out in such a period, it will be a victim of over-capitalisation because it has to spend huge amounts. 3. Buying assets of lower value at higher prices. It promoters buy assets of lower values at higher prices, they are led to a situation of over-capitalisation because assets of lower value will be shown at higher value in the Balance sheet. Causes of Over- Capitalisation: In simple words, over-trading means, “a situation where a company does more business than what its finances allow. It is related to the cash position of the enterprise, and it occurs when the company expands Over-Trading its scale of operations with insufficient cash resources”.  Inflation and Rising Prices: High Incidence of Taxation: Increased Lock-up of Funds in Stocks: Over-Expansion Causes of over trading Signs of Over-Trading: i. Increase in bank borrowings and loans. ii. Increase in stocks. iii. Purchase of fixed assets out of short-term funds. iv. Decline in the working capital ratio, i.e Working Capital/Sales or Working Capital/Production v. Decline in the rate of gross and net profits. vi. Low current ratio and very high turnover ratio. Signs of Over- Trading Consequences of Over-Trading: i. Inability of the management to pay wages to the employees and taxes to the government. ii. Decline in sales and costly purchases. iii. Difficulty in raising funds because of poor creditworthiness. iv. Problems with debtors and creditors. v. Inability of the management to carry out timely repairs and maintenance resulting in inefficient working. vi. Lack of funds will compel the company to go in for out-dated and old machinery for Consequences of replacement purpose. Over-Trading Remedies for Over-Trading: i. The company should cut down its business and over-spending or it should arrange for more funds. ii. Preventing a situation of over-trading by taking precautionary steps. Remedies for Over- Trading: Under-Trading: Under-trading is a condition contrary to over-trading. It is an application of idle funds. Too much investment in current assets and smaller amount of current liabilities results in under- trading. Under-Trading The consequence of under-trading are: (a) Reduction in profits. (b) Reduction in the rates of return on capital employed.