Financial Management

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chapter 1
Introduction to financial Management
Meaning Financial Management is a related aspect of finance function. In
the present business administration financial management is
an important branch. Nobody will think over about-business
activity without finance implication.
Financial management includes adoption of general
management principles for financial implementation. The
following may be said as the related aspects of financial
management raising of funds, using of these funds profitably,
planning of future activities, controlling of present
implementations and future developments with the help of
financial accounting, cost accounting, budgeting and statistics.
It acts as guidance where more opportunities for investment is
available. Financial management is useful as a tool for
allotment of resources to various projects depending on their
importance and repayment capacity.
Financial Management means planning, organizing, directing
and controlling the financial activities such as procurement and
utilization of funds of the enterprise. It means applying general
management principles to financial resources of the enterprise.

Definition:
1. James Van Morne defines Financial Management as
follows:
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Planning is an inextricable dimension of financial

management. The term financial management connotes that
funds flows are directed according to some plan. Financial
managements can be said a good guide for allotment of future
resources of an organisation.

2. The planning, directing, monitoring, organizing,

and controlling of the monetary resources of an organization.

3. According to Solomin Ezra, " financial management is

concerned with the the efficient use of an important economic
resource, namely capital funds".
4. According to the J.J Hampton "Financial management is
an applied field of business administration."

characteristic of Financial Accounting:Financial Accounting is the process in which business

transactions are recorded systematically in the various books of
accounts maintained by the organization in order to prepare
financial statements. These financial statements are basically
of two types: First is Profitability Statement or Profit and Loss
Account and second is Balance Sheet.
Following are the characteristics of Financial Accounting:
1) Monetary Transactions: In financial accounting only
transactions in monetary terms are considered. Transactions
not expressed in monetary terms do not find any place in
financial accounting, howsoever important they may be from
business point of view.

2) Historical Nature: Financial accounting considers only

those transactions which are of historical nature i.e the
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transaction which have already taken place. No futuristic

transactions find any place in financial accounting, howsoever
important they may be from business point of view.
3) Legal Requirement: Financial accounting is a legal
requirement. It is necessary to maintain the financial
accounting and prepare financial statements there from. It is
also obligatory to get these financial statements audited.
4) External Use: Financial accounting is for those people who
are not part of decision making process regarding the
organization like investors, customers, suppliers, financial
institutions etc. Thus, it is for external use.
5) Disclosure of Financial Status: It discloses the financial
status and financial performance of the business as a whole.
6) Interim Reports: Financial statements which are based on
financial accounting are interim reports and cannot be the final
ones.
7) Financial Accounting Process: The process of financial
accounting gets affected due to the different accounting
policies followed by the accountants. These accounting policies
differ mainly in two areas: Valuation of inventory and
Calculation of depreciation.

Function of Finance Management:The main Function of financial management is to

arrange sufficient finances for meeting short term and long
term needs. A financial manager will have to concentrate on
the following areas of finance function:
1.

Estimating Financial Requirements: -

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The first task of financial manager is to estimate

short term and long-term financial requirements of his
business. For this purpose, he will prepare a financial plan for
present as well as for future. The amount required for
purchasing fixed assets as well as for working capital will have
to be ascertained.
2.
Deciding Capital Structure: The capital structure refers to the kind and
proportion of different securities for raising funds. After
deciding about the quantum of funds required, it should be
decided which type of securities should be raised. It may be
wise to finance fixed assets through long-term debts and
current assets through short-term debts.
3.
Selecting a Source of Finance: After preparing capital structure, an appropriate
source of finance is selected. Various sources from which
finance may be raised include: share capital, debentures,
financial institutions, commercial banks, public deposits etc. If
finance is needed for short period then banks, public deposits
and financial institutions may be appropriate. On the other
hand, if long-term finance is required then, share capital, and
debentures may be useful.
4.
Selecting a pattern of Investment: When funds have been procured then a decision
about investment pattern is to be taken. The selection of an
investment pattern is related to the use of funds. A decision will
have to be taken as to which asset is to be purchased. The
funds will have to be spent first on fixed assets and then an
appropriate portion will be retained for working capital. The
decision-making techniques such as capital budgeting,
opportunity cost analysis etc. may be applied in making
decisions about capital expenditures.
5.
Proper cash Management: Cash management is an important task of
finance manager. He has to assess various cash needs at
different times and then make arrangements for arranging
cash. The cash management should be such that neither there
is a shortage of it and nor it is idle. Any shortage of cash will
damage the credit worthiness of the enterprise. The idle cash
with the business will mean that it is not properly used. Cash
flow statements are used to find out various sources and
application of cash.
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6.

Implementing Financial Controls:An efficient system of financial management

necessitates the use of various control devises. Financial
control devises generally used are budgetary control, break
even analysis; cost control, ratio analysis etc. The use of
various techniques by the finance manager will help him in
evaluating the performance in various areas and take corrective
measures whenever needed.
7.
Proper use of Surplus: The utilization of profit or surplus is also an
important factor in financial management. A judicious use of
surpluses is essential for expansion and diversification plan and
also in protecting the interest of shareholders. The finance
manager should consider the following factors before declaring
the dividend;
a.
Trend of earnings of the enterprise
b.
Expected earnings in future.
c.
Market value of shares.
d.
Shareholders interest.
e.
Needs of fund for expansion etc.

Importance of Financial Management:In a big organisation, the general manger or the managing
director is the overall in charge of the organisation but he gets
all the activities done by delegating all or some of his powers to
men in the middle or lower management, who are supposed to
be specialists in the field so that better results may be
obtained.
(i) success of Promotion Depends on Financial
Administration. One of the most important reasons of failures
of business promotions is a defective financial plan. If the plan
adopted fails to provide sufficient capital to meet the
requirement of fixed and fluctuating capital an particularly, the
latter, or it fails to assume the obligations by the corporations
without establishing earning power, the business cannot be
carried on successfully. Hence sound financial plan is very
necessary for the success of business enterprise.
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(ii) Smooth Running of an Enterprise. Sound Financial

planning is necessary for the smooth running of an enterprise.
Money is to an enterprise, what oil is to an engine. As, Finance
is required at each stage f an enterprise, i.e., promotion,
incorporation, development, expansion and administration of
day-to-day working etc., proper administration of finance is
very necessary. Proper financial administration means the
study, analysis and evaluation of all financial problems to be
faced by the management and to take proper decision with
reference to the present circumstances in regard to the
procurement and utilisation of funds.
(iii) Financial Administration Co-ordinates Various
Functional Activities. Financial administration provides
complete co-ordination between various functional areas such
as marketing, production etc. to achieve the organisational
goals. If financial management is defective, the efficiency of all
other departments can, in no way, be maintained. For example,
it is very necessary for the finance-department to provide
finance for the purchase of raw materials and meting the other
day-to-day expenses for the smooth running of the production
unit. If financial department fails in its obligations, the
Production and the sales will suffer and consequently, the
income of the concern and the rate of profit on investment will
also suffer. Thus Financial administration occupies a central
place in the business organisation which controls and coordinates all other activities in the concern.
(iv) Focal Point of Decision Making. Almost, every decision
in the business is take in the light of its profitability. Financial
administration provides scientific analysis of all facts and
figures through various financial tools, such as different
financial statements, budgets etc., which help in evaluating the
profitability of the plan in the given circumstances, so that a
proper decision can be taken to minimise the risk involved in
the plan.
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(v) Determinant of Business Success. It has been

recognised, even in India that the financial manger splay a very
important role in the success of business organisation by
advising the top management the solutions of the various
financial problems as experts. They present important facts and
figures regarding financial position an the performance of
various functions of the company in a given period before the
top management in such a way so as to make it easier for the
top management to evaluate the progress of the company to
amend suitably the principles and policies of the company. The
financial manges assist the top management in its decision
making process by suggesting the best possible alternative out
of the various alternatives of the problem available. Hence,
financial management helps the management at different level
in taking financial decisions.
(vi) Measure of Performance. The performance of the firm
can be measured by its financial results, i.e, by its size of
earnings Riskiness and profitability are two major factors which
jointly determine the value of the concern. Financial decisions
which increase risks will decrease the value of the firm and on
the to the hand, financial decisions which increase the
profitability will increase value of the firm. Risk an profitability
are two essential ingredients of a business concern.

Responsibilities of Financial Management:In the light of this wide diversity of organisational practices, it is
not surprising to find that in most of the company, financial
officer is responsible for the routine finance functions. The main
responsibilities of the financial officer are as follows:

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(1) Financial Planning. The main responsibility of the chief

financial officer in a large concern is to forecast the needs and
sources of finance and ensure the adequate supply cash at
proper time for the smooth running of the business. He is to see
that cash inflow and outflow must be uninterrupted and
continuous. For this purpose, financial planning is necessary,
i.e., he must decide the time when he needs money, the
sources of supply of money and the investment patterns so that
the company may meet its obligations properly and maintain its
goodwill in the market. The financial manager is also to see
that there is no surplus money in the business which earns
nothing.
(2) Raising of Necessary Funds. The second main
responsibility of the financial officer is to see the nature of the
need, i.e., whether finances are required for long-term or for
short-term. He must assess the alternative sources of supply of
finance taking into view the cost of raising funds, its effect on
various concerned parties, i.e, shareholders, creditors,
employees and the society, control and risk in financing and
elasticity in capital structure etc.
(3) Controlling the Use of Funds. The financial manager is
also responsible for the proper utilization of funds. Assets must
be used effectively so as to earn higher profits; inflow and
outflow of cash must be controlled in a manner so as to meet
the current as well as future obligations; unnecessary
expenditure should be curtailed and there should be left no
possibility for misappropriation of money.
(4) Disposition of Profits. Appropriation of profits is one of
the main responsibilities of the financial manger. He is to advise
to the top executive as how much of the profits should be
retained in the business as reserves for future expansion; how
much to be used in repaying the debts; and how much to be
distributed to the shareholders as dividend. On the basis of the
advice given by the financial mange, the resolutions regarding
depreciations, reserves, general reserves and distribution of
dividends are carried out in the meeting of the board of
directors of the company.
(5) Other Responsibilities. Over and above, the
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responsibilities sated above, there are certain other

responsibilities of the financial manger. These are:
(a) Responsibility to owners. Shareholders or stock-holders
are the real owners of the concern. Financial manger has the
prime responsibility to those who have committed funds to the
enterprise. He should not only maintain the financial health of
the enterprise, but should also help to produce a rate of earning
that will reward the owners adequately for the risk capital they
provide.
(b) Legal Obligations. Financial manager is also under an
obligation to consider the enterprise in the light of its legal
obligations. A host of laws, taxes and rules and regulations
cover nearly every move and policy. Good financial
management help to develop a sound legal framework.
(c) Responsibilities of Employees. The financial
management must try to produce a healthy going concern
capable of maintaining regular employment at satisfactory rate
of pay under favourable working conditions. The long term
financial interests of management, employees an owners are
common.
(d) responsibilities to Customers. In order to make the
payments of its customers' bill, the effective financial
management is necessary. Sound financial management
ensures the creditors continued supply of raw material.
(e) Wealth Maximization. Prof. Soloman of Stanford
University has argued that the main goal of the finance function
is wealth maximization. The other goals may be achieved
automatically.
In the light of the above discussion, we can conclude that the
main responsibility of the financial manger is not only to
maintain the financial health of the organisation but also to
increase the economic welfare of the shareholders by utilizing
the funds in an effective manner.

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Chapter 2
Financial
Goals
Goals Of Financial Management
All businesses aim to maximize their profits, minimize their expenses and
maximize their market share. Here is a look at each of these goals.

Maximize Profits
A company's most important goal is to make money and keep it. Profit-margin
ratios are one way to measure how much money a company squeezes from
its total revenue or total sales.
There are three key profit-margin ratios: gross profit margin, operating profit
margin and net profit margin.
1. Gross Profit Margin
The gross profit margin tells us the profit a company makes on its cost of sales
or cost of goods sold. In other words, it indicates how efficiently management
uses labor and supplies in the production process.
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Gross Profit Margin = (Sales - Cost of Goods Sold)/Sales

Suppose that a company has $1 million in sales and the cost of its labor and
materials amounts to $600,000. Its gross margin rate would be 40% ($1
million - $600,000/$1 million).
The gross profit margin is used to analyze how efficiently a company is using
its raw materials, labor and manufacturing-related fixed assets to generate
profits. A higher margin percentage is a favorable profit indicator.
Gross profit margins can vary drastically from business to business and from
industry to industry. For instance, the airline industry has a gross margin of
about 5%, while the software industry has a gross margin of about 90%.
2. Operating Profit Margin
By comparing earnings before interest and taxes (EBIT) to sales, operating
profit margins show how successful a company's management has been at
generating income from the operation of the business:
Operating Profit Margin = EBIT/Sales

If EBIT amounted to $200,000 and sales equaled $1 million, the operating

profit margin would be 20%.
This ratio is a rough measure of the operating leverage a company can
achieve in the conduct of the operational part of its business. It indicates how
much EBIT is generated per dollar of sales. High operating profits can mean
the company has effective control of costs, or that sales are increasing faster
than operating costs.Positive and negative trends in this ratio are, for the most
part, directly attributable to management decisions.
Because the operating profit margin accounts for not only costs of materials
and labor, but also administration and selling costs, it should be a much
smaller figure than the gross margin.
3. Net Profit Margin
Net profit margins are those generated from all phases of a business,
including taxes. In other words, this ratio compares net income with sales. It
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comes as close as possible to summing up in a single figure how effectively

managers run the business:
Net Profit Margins = Net Profits after Taxes/Sales

If a company generates after-tax earnings of $100,000 on its $1 million of

sales, then its net margin amounts to 10%.
Often referred to simply as a company's profit margin, the so-called bottom
line is the most often mentioned when discussing a company's profitability.
Again, just like gross and operating profit margins, net margins vary between
industries. By comparing a company's gross and net margins, we can get a
good sense of its non-production and non-direct costs like administration,
finance and marketing costs.
For example, the international airline industry has a gross margin of just 5%.
Its net margin is just a tad lower, at about 4%. On the other hand, discount
airline companies have much higher gross and net margin numbers. These
differences provide some insight into these industries' distinct cost structures:
compared to its bigger, international cousins, the discount airline industry
spends proportionately more on things like finance, administration and
marketing, and proportionately less on items such as fuel and flight crew
salaries.
In the software business, gross margins are very high, while net profit margins
are considerably lower. This shows that marketing and administration costs in
this industry are very high, while cost of sales and operating costs are
relatively low.
When a company has a high profit margin, it usually means that it also has
one or more advantages over its competition. Companies with high net profit
margins have a bigger cushion to protect themselves during the hard times.
Companies with low profit margins can get wiped out in a downturn. And
companies with profit margins reflecting a competitive advantage are able to
improve their market share during the hard times, leaving them even better
positioned when things improve again.

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Like all ratios, margin ratios never offer perfect information. They are only as
good as the timeliness and accuracy of the financial data that gets fed into
them, and analyzing them also depends on a consideration of the company's
industry and its position in the business cycle. Margins tell us a lot about a
company's prospects, but not the whole story.

Minimize Costs/Value:Companies use cost controls to manage and/or reduce their business
expenses. By identifying and evaluating all of the business's expenses,
management can determine whether those costs are reasonable and
affordable. Then, if necessary, they can look for ways to reduce costs through
methods such as cutting back, moving to a less expensive plan or changing
service providers. The cost-control process seeks to manage expenses
ranging from phone, internet and utility bills to employee payroll and outside
professional services.
To be profitable, companies must not only earn revenues, but also control
costs. If costs are too high, profit margins will be too low, making it difficult for
a company to succeed against its competitors. In the case of a public
company, if costs are too high, the company may find that its share price is
depressed and that it is difficult to attract investors.
When examining whether costs are reasonable or unreasonable, it's important
to consider industry standards. Many firms examine their costs during the
drafting of their annual budgets.

Role of Financial Management:In the area of finance and financial management, finance
manager is important authority. Not only to raise the finance of
company, finance manager do also other lots of works for
company. We can explain his role in following words.

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1. Role of Finance Manager for Raising Funds of Company

Finance manager checks different sources of company. He did
not get fund from all sources. First, he check his need in short
term and in long term and after this he select best source of
fund. He has also power to change the capital structure of
company for giving more benefit of company.
2. Role of Finance Manager for Taking Maximum Benefits from
Leverage Finance manager uses both operating and financial
leverage and try to use it for taking maximum benefit from
leverage.
3. Role of Finance Manager for International Financial Decision
Finance manager finds opportunities in international financial
decision. In these opportunities, he does the contracts of credit
default swap, interest rate swap and currency swap.
4. Role of Finance Manager in Investment Decisions Finance
manager checks the net present value of each investment
project before actual investment in it. Net present value of
project means what net profit at discount rate, will company
gets if company invests him money in that project. High NPV
project will be accepted. So, due to high responsibility, role of
finance manager in this regard is very important.
5. Role of Finance Manager in Risk Management Happening of
risks means facing different losses. Finance manager is very
serious on risk and its management. He plays important role to
find new and new ways to control risk of company. Like other
parts of management, he estimates all his risks, he organize
the employees who are responsible to control risk.He also
calculates risk adjusted NPV. He meets all risk controlling
organisations like insurance companies, rating agencies
at pervasive level. He is able to convert company's misfortunes
into fortunes. By good estimations of averse situations, he tries
his best to safeguard the money of company.

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Chapter 3
Capitalisation

Meaning and Definition of Capitalisation

The term capitalisation is derived from the word capital;
hence it would be appropriate to understand the meaning of
capital. Capital in business usage is mostly taken to mean
total assets required to operate in a business and the money
needed to acquire such assets.
The term capital in accounting literature means the net worth
of the company. Net worth means assets minus liabilities.
Economists use the term capital to mean all the accumulated
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wealth used to produce additional wealth. The debtors and

similar accounting claims, the intangible assets like goodwill
are excluded from the economists version of capital.
Capital, in the legal parlance of the term, is the amount
received in return for securities (shares allotted to the
investors). The total amount of share values paid as shown in
the companys books of accounts is legally known as its capital.
The term capitalisation is used in relation to companies and not
in respect of sole proprietorships and partnership firms.
Different views have been expressed on the concept and
definition of capitalisation by various authors in the context of
corporate sector.
Some authors have given it a broad meaning while others have
used it in a narrow sense. According to first school of thought,
capitalisation has been defined to include the amount of
capital to be raised; the securities through which it is to be
raised and the relative proportions of various classes of
securities to be issued, and also the administration of capital.
The analysis of this definition clearly shows that capitalisation is
synonymous with financial planning. Besides the amount of
capital required in a business, it decides about the
determination of the form and the relative proportions of the
various classes of securities to be issued and administration of
policies concerning capital.

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Lillin Doris, Gilbert Harold and Charles Gerstenberg have given

narrow interpretation of the term capitalisation. They feel that
the term capitalisation refers to the amount at which a
companys business can be valued.

DEFINITION OF 'CAPITALIZATION
1. In accounting, it is where costs to acquire an asset are
included in the price of the asset.
2. The definition of capitalization refers to writing in uppercase
letters, or the total invested in a business or the total value of
stocks and bonds of a corporation.
3. The debt and/or equity mix that funds a firm's assets.
4. When a company has issued more debt and equity than its
assets are worth. An overcapitalized company might be paying
more than it needs to in interest and dividends. Reducing debt,
buying back shares and restructuring the company are possible
solutions to this problem.

In the insurance market, overcapitalization occurs when supply

exceeds demand, creating a soft market and causing insurance
premiums to decline until the market stabilizes.

Over-capitalization:Meaning of Over-capitalization:
It is the capitalization under which the actual profits of the
company are not sufficient to pay interest on debentures and

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borrowings and a fair rate of dividend to shareholders over a

period of time. In other words, a company is said to be overcapitalised when it is not able to pay interest on debentures
and loans and ensure a fair return to the shareholders.
We can illustrate over-capitalisation with the help of an
example. Suppose a company earns a profit of Rs. 3 lakhs. With
the expected earnings of 15%, the capitalisation of the
company should be Rs. 20 lakhs. But if the actual capitalisation
of the company is Rs. 30 lakhs, it will be over-capitalised to the
extent of Rs. 10 lakhs. The actual rate of return in this case will
go down to 10%. Since the rate of interest on debentures is
fixed, the equity shareholders will get lower dividend in the
long-run.

Definition:Situation where a firm has more capital than it catered-for

or needs. Thus, its assets are worth less than its issued share
capital, and the earnings are insufficient to pay dividend and
interest. This situation is remedied generally by buying back
issued shares (stock) or by paying off debt.

There are three indicators of over-capitalisation,

namely:
(a) The amount of capital invested in the companys business is
much more than the real value of its assets.
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(b) Earnings do not represent a fair return on capital employed.

(c) A part of the capital is either idle or invested in assets which
are not fully utilised.

Causes of Over-Capitalisation:
Over-capitalisation may be the result of the following
factors:
(i) Acquisition of Assets at Higher Prices:
Assets might have been acquired at inflated prices or at a time
when the prices were at their peak. In both the cases, the real
value of the company would be below its book value and the
earnings very low.
(ii) Higher Promotional Expenses:
The company might incur heavy preliminary expenses such as
purchase of goodwill, patents, etc.; printing of prospectus,
underwriting commission, brokerage, etc. These expenses are
not productive but are shown as assets.
(iii) Underutilisation:
The directors of the company may over-estimate the earnings
of the company and raise capital accordingly. If the company is
not in a position to invest these funds profitably, the company
will have more capital than is required. Consequently, the rate
of earnings per shares will be less.

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(iv) Insufficient Provision for Depreciation:

Depreciation may be charged at a lower rate than warranted by
the life and use of the assets, and the company may not make
sufficient provisions for replacement of assets. This will reduce
the earning capacity of the company.
(v) Liberal Dividend Policy:
The company may follow a liberal dividend policy and may not
retain sufficient funds for self-financing. This may lead to overcapitalisation in the long-run.
(vi) Inefficient Management:
Inefficient management and extravagant organisation may also
lead to over-capitalisation of the company. The earnings of the
company will be low.

evil measures of over capitalisation:Over-capitalisation has evil consequences from the point of
view of the company, the society and the shareholders.
From the point of view of the company
(a) over-capitalisation will result in considerable reduction of
the rate of dividend on the equity shares issued. This is
because the profits which the company earns have to be
distributed over an unnecessarily large number of shares.
(b) With the disappearance of reduction of dividends, the
market value of the shares falls, and the investors lose
confidence in the company. The credit of the company suffers a
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setback. Should a company require more funds for the

purposes of bringing about any improvement or acquiring new
assets, it will find it extremely difficult to raise the necessary
fund from the market.
(c) Sometimes the company resorts to questionable practices
including 'window dressing' in order to show a respectable
figure of profits. Some people are downright dishonest and
merely cook up an increase. Others avoid necessary
expenditure so that the debit in the profit and loss account is
reduced. In the latter case, the efficiency of the company will
be still further undermined. For example, if maintenance of
machinery and repairs to machinery are postponed, the
damage to the machinery will be very heavy and the efficiency
would be greatly reduced. This will further reduce profits.
(d) It is often found that an over-capitalized company has to go
into liquidation, unless drastic steps are taken to re-organise
the share capital. Re-organisation would again mean
considerable loss of goodwill.
From the point of view of society
(a) Over-capitalisation is an indication of reduced efficiency. An
over-capitalized concern is compelled to raise the prices of its
products. With diminished efficiency it is usually not able to
maintain the quality of its products. Thus, the public is a loser
both as regards price an quality.
(b) An over-capitalized company may try to raise its profits by
effecting cuts in wages of workers. This may affect industrial
relations.
(c) Since an over-capitalized concern is unable to compete with
other concerns, it may have to close down. The closure of a few
companies in this manner may well become the cause of
general panic and alarm. This would affect the interests of the
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creditors. The workers would also lose their jobs.

(d) Over-capitalisation results in misapplication of society's
resources. The capital lying idle or being under-utilised by an
over-capitalized concern can be better utilised by other
concerns which are in need of funds.
The shares of an over-capitalized concern provide scope for
gambling on the stock exchange. It is undesirable from the
social point of view.

From the shareholders' point of view

(a) Over-capitalisation means depreciation of investment. The
shares of an over-capitalized company sell below par in the
market. Originally the shareholders may have paid much more
for them.
(b) The shareholders have also to suffer due to a low return on
their investment which, too, is not always certain and regular.
(c) The shares of an over-capitalized company have relatively
have relatively small value as security for loans which a
shareholder may like to raise.
(d) The low-priced shares of an over-capitalized concern are
subject to speculative gambling. This harms the interests of the
real investors.
(e) When an over-capitalized concern tries to set its house in
order through reorganisation, the shareholders are the worst
suffers. Re-orgnaisation would usually take the form of
reduction of capital for writing off past losses. Such a
reeducation has to be borne by the shareholders. In the event
of liquidation too, the shareholders have to content themselves
with much less than their original investment.
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Remedies for Over-capitalization:

In order to correct the situation caused by overcapitalisation, the following measures should be
adopted:
(i) The earning capacity of the company should be increased by
raising the efficiency of human and non-human resources of the
company.
(ii) Long-term borrowings carrying higher rate of interest may
be redeemed out of existing resources.
(iii) The par value and/or number of equity shares may be
reduced.
(iv) Management should follow a conservative policy in
declaring dividend and should take all measures to cut down
unnecessary expenses on administration.

Under-Capitalization

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Meaning of Under-capitalization:
A company is said to be under-capitalised when it is earning
exceptionally higher profits as compared to other companies or
the value of its assets is significantly higher than the capital
raised. For instance, the capitalisation of a company is Rs. 20
lakhs and the average rate of return of the industry is 15%. But
if the company is earning 30% on the capital investment, it is a
case of under-capitalisation.
The assets acquired with the existing capitalisation
facilitate the generation of higher profits. It so happens
when:
(i) The assets have been acquired at lower rates, or
(ii) The company has generated secret reserves by paying
lower dividends to the shareholders over a number of years.
The indicators of under-capitalisation are as follows:
(a) There is an unforeseen increase in earnings of the company.
(b) Future earnings of the company were under-estimated at
the time of promotion.
(c) Assets might have been acquired at very low prices.

Causes of Under-capitalisation:
Under-capitalisation may be caused by the following
factors:
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(i) Acquisition of Assets during Recession:

Assets might have been acquired at low costs during necessary
conditions in the market. And now higher incomes are being
earned by their use.
(ii) Under-estimation of Requirements:
There may be under-estimation of capital requirements of the
company by the promoters. This may lead to capitalisation
which is insufficient to conduct its operations.
(iii) Conservative Dividend Policy:
The management may follow a conservative dividend policy
leading to higher rate of ploughing back of profits. This would
increase the earning capacity of the company.
(iv) Efficient Management:
The management of a company may be highly efficient. It may
issue the minimum share capital and may meet the additional
financial requirements through borrowings at lower rates of
interest.
(v) Creation of Secret Reserves:
A company may have large secret reserves due to which its
profitability is higher.

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Remedies for Under-capitalization:

The following remedial steps may be taken to correct
under-capitalisation of a company:
(i) Under-capitalisation may be remedied by increasing the par
value and/or number of equity shares by revising upward the
value of assets. This will lead to decrease in the rate of
earnings per share.

(ii) Management may capitalise the earnings by issuing bonus

shares to the equity shareholders. This will also reduce the rate
of earnings per share without reducing the total earnings of the
company.
(iii) Where under-capitalisation is due to insufficiency of capital,
more shares and debentures may be issued to the public.

Difference between Over Capitalization and

Under Capitalization of Company!
Over Capitalization:
A company is said to be overcapitalized when the aggregate of
the par value of its shares and debentures exceeds the true

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value of its fixed assets.In other words, over capitalisation takes

place when the stock is watered or diluted.
It is wrong to identify over capitalisation with excess of capital,
for there is every possibility that an over capitalised concern
may be confronted with problems of liquidity. The current
indicator of over capitalisation is the earnings of the company.
If the earnings are lower than the expected returns, it is
overcapitalised. Overcapitalisation does not mean surplus of
funds. It is quite possible that a company may have more funds
and yet to have low earnings. Often, funds may be inadequate,
and the earnings may also be relatively low. In both the
situations there is over capitalisation.
Over capitalisation may take place due to exorbitant
promotion expenses, inflation, shortage of capital, inadequate
provision of depreciation, high corporation tax, liberalised
dividend policy etc. Over capitalisation shows negative impact
on the company, owners, consumers and society.
Under capitalization:
Under capitalisation is just the reverse of over capitalisation, a
company is said to be under capitalised when its actual
capitalisation is lower than its proper capitalisation as
warranted by its earning capacity. This happens in case of well
established companies, which have insufficient capital but,
large secret reserves in the form of considerable appreciation in
the values of fixed assets not brought into books.
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In case of such companies, the dividend rate will be high and

the market value of their shares will be higher than the value of
shares of other similar companies. The state of under
capitalisation of a company can easily be ascertained by
comparing of a book value of equity shares of the company
with their real value. In case real value is more than the book
value, the company is said to be under capitalised.
Under capitalisation may take place due to under estimation
of initial earnings, under estimation of funds, conservative
dividend policy, windfall gains etc. Under-capitalisation has
some evil consequences like creation of power competition,
labour unrest, consumer dissatisfaction, possibility of
manipulating share value etc..

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