What is over capitalization and under capitalization?

What are the effects of over

capitalization? Is over capitalization good for company?
Over Capitalization

Over capitalization refers to the company which possesses an excess of capital in relation to its
activity level and requirements. In simple means, over capitalization is more capital than actually
required and the funds are not properly used.

According to Bonneville, Dewey and Kelly, over capitalization means, “when a business is unable to
earn fair rate on its outstanding securities”.

Example

A company is earning a sum of Rs. 50,000 and the rate of return expected is 10%. This company will
be said to be properly capitalized. Suppose the capital investment of the company is Rs. 60,000, it
will be over capitalization to the extent of Rs. 1,00,000. The new rate of earning would be:
50,000/60,000×100=8.33% When the company has over capitalization, the rate of earnings will be
reduced from 10% to 8.33%.

Under Capitalization

Under capitalization is the opposite concept of over capitalization and it will occur when the
company’s actual capitalization is lower than the capitalization as warranted by its earning capacity.
Under capitalization is not the so-called inadequate capital. Under capitalization can be defined by
Gerstenberg, “a corporation may be undercapitalized when the rate of profit is exceptionally high in
the same industry”. Hoagland defined under capitalization as “an excess of true assets value over
the aggregate of stocks and bonds outstanding”.

Effects of Over Capitalization

Over capitalization leads to the following important effects:

• Reduce the rate of earning capacity of the shares.

• Difficulties in obtaining necessary capital to the business concern.

• It leads to fall in the market price of the shares.

• It creates problems on re-organization.

• It leads under or misutilization of available resources.

over capitalization is not good for company, because it results in following disadvantages
(i) Poor Credit-Worthiness
(ii) (ii) Reduction in the Rate of Dividend
(iii) Loss to Shareholders
(iv) Loss to Employees and Labourers
(v) Loss to Creditors
What is financial management? Difference between financial accounting and financial
management
Financial management refers to efficient acquisition, allocation and usage of funds by a company for
its smooth working.

 The main objectives of financial management are to reduce the expenses involved in procuring
funds, to control risk and to achieve effective deployment of funds.

Importance of Financial Management

 The role of financial management is as such that it has a direct impact on all the financial
aspects/activities of a company. Certain aspects affected by financial management decisions are

1. Size and composition of fixed assets: The amount of money invested in fixed assets is an outcome
of investment decisions. So, if more amount of capital is decided to be invested in fixed assets, then
it will increase the value of the total share of fixed assets by the amount invested.

2. Amount and composition of current assets: The quantum of current assets and its constituents
like cash, bills receivable, inventory etc. is also influenced by management decisions. It is also
dependent on the amount invested in fixed assets, decisions about credit and inventory
management etc.

3. Amount of long-term and short-term funds to be used: Financial management determines the
quantum of funds to be raised for the short term and long term. In case a firm requires more liquid
assets, then it will prefer to have more long-term finance even when their profits will decrease due
to payment of more interest in comparison to shortterm debts.

4. Proportion of debt and equity in capital: Financial management also takes decisions regarding the
proportion of debt and/or equity.

5. All items in profit and loss account: All items in the profit and loss account are affected by
financial management decisions. For example, higher amount of debt will lead to increase in the
expense in the form of interest payment in the future.
 BASIS FOR COMPARISON FINANCIAL ACCOUNTING FINANCIAL MANAGEMENT
Financial Accounting is an accounting
Financial Management refers to the
system that captures the records of
managerial activity, that stresses on the
financial information about the
Meaning management of firm's financial
business to show the correct financial
resources, to achieve the overall aim of
position of the company at a particular
the enterprise.
date.
It involves assets and resources of the
Focused on It is primarily focused on reporting
company and their effective utilization
The main objective of financial The main objective of financial
Objective accounting is to provide financial management is profit maximization and
information using standard procedures wealth/value maximization.
It involves reporting past financial It involves planning about future
Time of reporting
transactions financial transactions
It reports the financial information to
It is used by the management of the
PrimaryUse the management, creditors, investors,
company to forecast its future.
analysts, and regulators 
Accounting involves in reporting
Financial management involves the
financial information using standard
Importance assets and resources of the Company
procedures and rules in a meaningful
and their effective utilization.
form of financial statements.
Measurement of fund Accrual basis Cash flow basis
Purpose of accounting is to collect and Financial management involves to uses
Purpose present the data in a meaningful this data for financial decision making
manner purpose.
Management can do this activity at any
Timeframe Quarterly, Half-Yearly, and Yearly
time.
Summary reports in the form of Detailed report on the future course of
Reports
financial statements action.

What is dividend policy? And Factors affecting dividend policy of any company?
A dividend policy is the policy a company uses to structure its dividend payout to shareholders. 

 Dividends are often part of a company's strategy. However, they are under no obligation to
repay shareholders using dividends.

 Stable, constant, and residual are the three types of dividend policy.

 Even though investors know companies are not required to pay dividends, many consider it
a bellwether of that specific company's financial health.

FACTORS DETERMINING DIVIDEND POLICY

 Profitable Position of the Firm

Dividend decision depends on the profitable position of the business concern. When

the firm earns more profit, they can distribute more dividends to the shareholders.

 Uncertainty of Future Income

Future income is a very important factor, which affects the dividend policy. When the

shareholder needs regular income, the firm should maintain regular dividend policy.

 Legal Constrains

The Companies Act 1956 has put several restrictions regarding payments and declaration

of dividends. Similarly, Income Tax Act, 1961 also lays down certain restrictions on

payment of dividends.

 Liquidity Position

Liquidity position of the firms leads to easy payments of dividend. If the firms have high

liquidity, the firms can provide cash dividend otherwise, they have to pay stock dividend.

 Sources of Finance

If the firm has finance sources, it will be easy to mobilize large finance. The firm

shall not go for retained ear ni ngs .

 Growth Rate of the Firm

High growth rate implies that the firm can distribute more dividends to its shareholders.

 Tax Policy

Tax policy of the government also affects the dividend policy of the firm. When

the government gives tax incentives, the company pays more dividends.

 Capital Market Conditions

Due to the capital market conditions, dividend policy may be affected. If the capital market
is prefect, it leads to improve the higher dividend

Short Note

Capital Structure

Capital structure refers to the kinds of securities and the proportionate amounts that make up
capitalization. It is the mix of different sources of long-term sources such as equity shares,
preference shares, debentures, long-term loans and retained earnings.

The term capital structure refers to the relationship between the various long-term source financing
such as equity capital, preference share capital and debt capital. Deciding the suitable capital
structure is the important decision of the financial management because it is closely related to the
value of the firm.

Capital structure is the permanent financing of the company represented primarily by long-term
debt and equity

Long-Term Sources of Finance

Long-term financing means capital requirements for a period of more than 5 years to 10, 15, 20
years or maybe more depending on other factors. Capital expenditures in fixed assets like plant and
machinery, land and building, etc of business are funded using long-term sources of finance. Part of
working capital which permanently stays with the business is also financed with long-term sources of
funds. Long-term financing sources can be in the form of any of them:

 Share Capital or Equity Shares

 Preference Capital or Preference Shares
 Retained Earnings or Internal Accruals
 Debenture / Bonds
 Term Loans from Financial Institutes, Government, and Commercial Banks
 Venture Funding
 Asset Securitization
 International Financing by way of Euro Issue, Foreign Currency Loans, ADR, GDR, etc.

TRADING ON EQUITY

 Trading on equity is a financial process in which debt produces gain for shareholders of a
company. Trading on equity happens when a company incurs new debt using bonds, loans,
bonds or preferred stock. The company then uses these funds to gain assets which will
create returns which are larger than the interest of the new debt. Alternatively, trading on
equity called financial leverage. If it helps the company to generate profit and results in a
higher return for the shareholders on their investment, it is considered a success. Companies
usually go this way to boost earnings per share.

 ‘Trading on equity’ is called so because the company gets its loan amount from the creditors
based on its equity strength. Companies usually borrow funds at favourable terms by taking
advantage of their equity. If the amount borrowed is large as compared to the company’s
 equity, it is categorised as ‘trading on thin equity.’ When the borrowed amount is modest,
the company is ‘trading on thick equity.’

Borrowed funds
It is a well known fact that a business needs money in order to continue its operations. A
business cannot sustain for long without funds.
Funds can be of two types namely 1. Equity funds and 2. Borrowed funds.
Borrowed funds are referred to as the funds that a business needs to borrow from outside the
company in order to provide a source of capital for the business. These funds are different
from the capital owned by the company which are called equity funds.

Source of Borrowed Funds

The sources of borrowed funds include finance that is obtained from commercial banks,
financial institutions, finance that is raised from debenture holders and public deposits.

Features of Borrowed Funds

Following are some of the features of borrowed funds
1. Borrowed funds are raised by business for certain fixed time periods, it can be short-term,
medium-term or long-term, based on the requirement of the business.
2. Borrowed funds can be obtained against securities of the fixed assets of the business.
3. Businesses need to make regular interest payment for the loans obtained as funds as well as
need to pay the principal amount after a fixed time.
4.The security holders of the borrowed funds do not have control over the business activities
of the firm. They can however sue the firm in case there is default in payment of loan.

Commercial Organization
An organization is a group of people who work together on a set of common goals. If the
main goal of the organization is to earn a profit from the sale of products and services, it is a
commercial organization. This type of organization distributes any income that remains after
paying all business expenses to employees and investors or reinvests it into the company.
For the purposes of federal tax collection, a commercial organization is an incorporated
business. As such, each member of the organization benefits from limited-liability protection.
In addition, the organization maintains full control over how much of its profits it will retain
or distribute to shareholders.

Commercial Organization Design

Designing a commercial organization presents unique challenges for both leaders and
employees. The sales and marketing functions have a direct impact on customers so it is
important their design creates both a superior customer experience and differentiated
marketplace value for the company.
To stand out from the competition, every member of a commercial organization must
understand what makes their company unique and have the skills to deliver differentiation
based on their role. For this reason, it is important to consider marketplace differentiation
when making design choices for an organization. To achieve market differentiation, there are
four main points to keep in mind. They are:

 Market position

 Market segmentation

 Complexity
 Sales behaviors