How can your Business be affected by Over-Capitalization?
The way the capital is structured in a business can mean a lot to a business. The capital structure will pave the way for the future investments of the company and will also help in deciding the path the business should take. The amount of capital present for a particular phase will also help set deadlines and benchmarks which will assist in increasing the profitability of the company.
The blog below will help you understand what is overcapitalization and how can it affect your business.
Capitalization Structure: Definition
The capitalization structure refers to all the money which is used to fund all the activities of the business and how this money is obtained. A business can obtain funds via Equity financing which is the sale of stock to a shareholder or Debt financing in which the company gathers funds from various debt instruments such as Bank Loans, Personal Loans, Credit Cards, etc.
There is a clear difference between Debt financing and Equity financing as in equity financing the value of the stock or share of the company can rise or fall according to the market conditions but in debt financing, the value of the loan must be returned back with some interest at a later date.
The management should see to it that the proper amount of funds is available to the business. this means that a business should have a mixture of capital both from debt as well as equity. Each type of capital has its own pros and cons.
Effects of Over Capitalization
A company faces overcapitalization when a greater debt, as well as equity, is present as compared to the assets of the company. Capitalization can create adverse effects on the business such as:
- Greatly diminishes the goodwill and credit worthiness of the company
This move will not only diminish the creditworthiness but will also affect the goodwill of the company in a negative manner. This will affect the number of people who are interested to invest in the company. When the company accounts are prepared then the management will be able to see a great loss in the goodwill of the Company.
- It creates difficulty in generating additional funds
Over capitalization brings down the financial reputation of the company and as a result, the creditworthiness of the company decreases. Due to this, the business is not able to get any more loans in the future.
- It drives up the Rate of Interest in the future
As the business is already over capitalised, the business will not be able to receive any more funds from the shareholders of the company. this means that the business will be able to get loans only at a higher rate of interest.
- May lead to unfair practises by the business
Overcapitalization may lead to a decrease in the capacity to earn by the business. in order to show good numbers, the management of the business will have to resort to the following of wrong and unhealthy business practices.
- Effect on the workers
As the profitability of a company decreases due to overcapitalization, the company may try to reduce the wages of the workers or may withdraw any amenities to compensate. this will not only reduce the morale of the workers but will also affect the efficiency of the workers in a negative way.
- Effect on Shareholders
The shareholders of an over capitalised company face a number of difficulties with respect to its capital structure. This means that the return value of the share diminishes and is erratic and irregular. The market value of all of their holdings gets reduced and provide a very small value when treated as collateral against any loan. One of the biggest effects of Over Capitalization over the shareholders is that when an overcapitalized business reorganises itself, the shareholders are the people who suffer the most.
It is very important for the management to understand the workings of a business and plan ahead for the future of the business. If you are looking for help in such planning for your business in the UAE, then you can take the help of JAXA Chartered Accountants.
They also provide various other services such as Auditing Services, Accounting Services, and various other services which will help your company to flourish in the market. For any more details on the services provided by JAXA, Contact Us. We will be happy to help.
