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Q: compare and contrast the pros and cons of over capitalization and under capitalization
A: Under-Capitalization: Definition and Explanation of Under Capitalization: If the owned capital of the business is much less than the total borrowed capital than it is a sign of under capitalization. [ This means that the owned capital of the company is disproportionate to the scale of its operation and the business is dependent upon borrowed money and trade creditors. Under-capitalization may
be the result of over-trading. It must be distinguished from high gearing. Incase of capital gearing there is a comparison between equity capital and fixed interest bearing capital (which includes reference share capital also and excludes trade creditors) whereas in the case of under capitalization, comparison is made between total owned capital (both equity and preference share capital) and total borrowed capital (which includes trade creditors also). Under capitalization is indicated by: Low proprietary Ratio Current Ratio High Return on Equity Capital The effects of under capitalization may be: Payment of excessive interest on borrowed capital. Use of old and out of date equipment because of inability to purchase new plant etc. High cost of production because of the use of old machinery Over-Capitalization: Definition and Explanation of Over Capitalization: A concern is said to be over-capitalized if its earnings are not sufficient to justify a fair return on the amount of share capital and debentures that have been issued. It is said to be over capitalized when total of owned and borrowed capital exceeds its fixed and current assets i.e. when it shows accumulated losses on the assets side of the balance sheet. An over capitalized company can be like a very fat person who cannot carry his weight properly. Such a person is prone to many diseases and is certainly not likely to be sufficiently active. Unless the condition of overcapitalization is corrected, the company may find itself in great difficulties. CONTINUATION:l ]
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Asked 3/5/2012 1:47:49 AM
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