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Under-Capitalisation: Causes, Effects and Remedies
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After reading this article you will learn about the Under-Capitalisation:- 1. Meaning of Under-Capitalisation 2. Causes of Under-Capitalisation 3. Effects 4. Remedies.
Meaning of Under-Capitalisation:
In the words of Gersrtenberg, “A company may be under-capitalised when the rate of profits it is making on the total capital is exceptionally high in relation to the return enjoyed by similarly situated companies in the same industry, or when it has too little capital with which to conduct its business”.
In simple words, we can say that under-capitalisation is the reverse phenomenon of over-capitalisation, and occurs when a company’s actual capitalisation is lower than its proper capitalisation as warranted by its earning capacity. The term under-capitalisation should never be considered synonymous with inadequate capital.
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The real value of an under-capitalised company is more than its book value. The profits are higher than warranted by the book value of its assets. Such a company can pay a higher rate of dividend and the market value of its shares is much higher than its face value.
Causes of Under-Capitalisation:
Following are the important causes of under-capitalisation in a company:
1. Under-Estimation of Capital Requirements:
If the future capital requirements are underestimated by the promoters, the inadequacy of capital is experienced at a later stage. The company may arrange cheaper debt at lower rate of interest at that stage resulting in increased earnings per share. This leads the company to a situation of under-capitalisation.
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2. Under-Estimation of Future Earnings:
While preparing the financial plan, if the future earnings of the company are under estimated and the actual earnings turn out to be higher than the estimated figure, the company may find itself in a condition of under-capitalisation.
3. Promotion during Depression:
Companies promoted during a period of depression often experience under-capitalisation when inflation sets in because of a sudden rise in their earnings.
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4. Conservative Dividend Policy:
If the management of a particular company adopts an orthodox dividend policy, i.e. where it follows a cautious policy regarding the distribution of dividend and keeps a major part of its earnings for re-investment purpose, it results into higher earnings and conditions of under-capitalisation.
5. Very Efficient Management:
In companies, where the management is very efficient, the rate of return may be quite high as compared to other companies in the same industry, and such a high rate of return may eventually lead towards under-capitalisation.
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6. Desire of Control and Trading on Equity:
In many companies, the promoter desires to retain control over the company and raises lesser amount of share capital. However, later on when the funds are required they resort to trading on equity. This raising of funds at a lower rate of interest than the earnings of the company eventually leads to under-capitalisation.
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