What Is Overcapitalization? Definition, Causes, and Example

What Is Overcapitalization?

The term overcapitalization refers to a situation wherein the value of a company's capital is worth more than its total assets. Put simply, there is more debt and equity compared to the value of its assets. When a company is overcapitalized, its market value is less than its total capitalized value or its current value. An overcapitalized company may end up paying more in interest and dividend payments than it can sustain in the long term. Being overcapitalized means that a company's capital management strategies are running inefficiently, placing it in a poor financial position.

Understanding Overcapitalization

Capitalization is a term used in corporate finance to describe the total amount of debt and equity held by a company. As such, it defines the total amount of money that is invested in the company itself. This includes both stocks and bonds. Companies can be either undercapitalized or overcapitalized. Here, we focus on the latter but we go over what it means to be undercapitalized a little further down.

Being overcapitalized means that a corporation's issued capital exceeds its operational needs. The heavy debt burden and associated interest payments that an overcapitalized entity carries can be a strain on profits and reduce the amount of retained funds the company has to invest in research and development (R&D) or other projects. Raising capital may be difficult as a company's stock may lose value in the market. As a whole, being overcapitalized puts a strain on its earning potential.

There are several reasons why companies may find themselves in a position where they are overcapitalized. Some of the most common causes of overcapitalization include:

• Acquiring assets that don't fit with the company's operations
• Purchasing high-priced assets
• Very high initial or startup costs, which can appear as assets on a company's balance sheet
• Loss of or drop in earnings due to changing economic or political conditions
• Poor management

Companies may also find themselves at risk of becoming overcapitalized when they either mismanage or underutilize the capital they have at their disposal.

An overcapitalized company has several options available to correct the situation. Some of these options include:

• Reducing its debt load by refinancing or restructuring debt
• Cutting interest payments by paying off long-term debts
• Conducting a share buyback from investors, which can effectively reduce a company's dividend payments
  

If none of these options is viable, the company may want to seek out a merger or be acquired by another entity.

Special Considerations

Although it may seem detrimental to a business, there is one advantage to being overcapitalized. When a company finds itself in this situation, it may have excess capital or cash on its balance sheet. This cash can earn a nominal rate of return (RoR) and increase the company's liquidity.

The excess capital also means the company has a higher valuation and can claim a higher price in the event of an acquisition or merger. Additional capital can also be used to fund capital expenditures, such as R&D projects.

Overcapitalization vs. Undercapitalization

The opposite of overcapitalization is undercapitalization. Just like overcapitalization, being undercapitalized is not where any company wants to be.

Undercapitalization occurs when a company has neither sufficient cash flow nor access to the credit it requires to finance its operations. The company may not be able to issue stock on the public markets because the company does not meet the requirements or because the filing expenses are too high.

Essentially, the company cannot raise capital to fund itself, its daily operations, or any expansion projects. Undercapitalization most commonly occurs in companies with high start-up costs, too much debt, and insufficient cash flow. Undercapitalization can ultimately lead to bankruptcy.

Example of Overcapitalization

Here's a hypothetical example to show how overcapitalization works. Assume that construction firm Company ABC earns $200,000 and has a required rate of return of 20%. The fairly capitalized capital is $1,000,000 or $200,000 ÷ 20%.

Instead of $1,000,000, Company ABC decides to use $1,200,000 as its capital. The rate of earnings in this case becomes 17% or $200,000 ÷ $1,200,000 x 100. Due to overcapitalization, the rate of return has dropped from 20% to 17%