Capitalization

Terms

What is Capitalization?

Capitalization is an accounting method in which a cost is included in the value of an asset and expensed over the useful life of that asset, rather than being expensed in the period the cost was originally incurred. In addition to this usage, market capitalization refers to the number of outstanding shares multiplied by the share price, which is a measure of the total market value of a company.

Capitalization has multiple meanings. In accounting, capitalization refers to the process of expensing the costs of attaining an asset over the life of the asset, rather than the period the expense was incurred. Rather than listing the asset as an expense, the asset is added to the company’s balance sheet and depreciated over its useful life.

In finance, capitalization refers to the sum of a corporation’s stock, long-term debt and retained earnings. Retained earnings are the percentage of net earnings retained by the company to be reinvested in its core business or to pay off debt.

The finance field also uses the term capitalization to refer to the number of a corporation’s outstanding stocks multiplied by the stock’s share price. This is also called the market capitalization.

What Does Capitalization Mean?

All costs that benefit more than one accounting period or fiscal year are required to be capitalized according to GAAP. This is consistent with the matching principle because revenues and expenses are matched in each accounting period.

In accounting, most revenue and expenses are recorded during the time they are incurred. However, the company may benefit by expensing certain assets over more than one accounting period. This typically takes place with large assets that may be expenses over a 20- to 30-year period.

Book value is another term for capitalization within the finance field. When investors talk about a company’s book value, they’re referring to the sum of the company’s stock, long-term debt, and retained earnings.

To determine a company’s market capitalization, multiply the company’s outstanding stocks by its share price. Companies with a market capitalization between $300 million and $2 billion are classified as small-cap companies.

Those with a market capitalization between $2 billion and $10 billion are considered mid-cap companies, and those above $10 billion are considered large-cap companies.

Example

For instance, a company vehicle will last more than one accounting period. It will probably last ten or more accounting periods. The matching principle states that the vehicle can’t be recorded as an expense in the year that it was purchased because this would not match future revenues with future expenses. All of the expense the vehicle would be recognized the year it was purchased. Instead, the vehicle is capitalized and is recorded as an asset. Since all asset accounts are permanent accounts, the vehicle will remain on the balance sheet for future periods.

The vehicle can then be depreciated each year over its useful life. Thus, capitalization matches future revenues with future expenses.

Some costs or expenses that last for future years are not always capitalized like repairs and improvements. Repairs made to the company vehicle are not typically capitalized. Instead, they are usually expensed in the current year. As a general rule of thumb, large assets purchases should always be capitalized while smaller assets and di minimis purchases are usually expensed.

Types of Capitalization

There are two key types of capitalizations, one of which is applied in accounting and the other in finance.

Accounting

In accounting, the matching principle requires companies to record expenses in the same accounting period in which the related revenue is incurred. For example, office supplies are generally expensed in the period when they are incurred since they are expected to be consumed within a short period of time. However, some larger office equipment may provide a benefit to the business over more than one accounting period.

These items are fixed assets, such as computers, cars, and office buildings. The costs of these items are recorded on the general ledger as the historical cost of the asset. Therefore, these costs are said to be capitalized, not expensed.

Capitalized assets are not expensed in full against earnings in the current accounting period. A company can make a large purchase but expense it over many years, depending on the type of property, plant, or equipment involved.

As the assets are used up over time to generate revenue for the company, a portion of the cost is allocated to each accounting period. This process is known as depreciation (or amortization for intangible assets).

For leased equipment, capitalization is the conversion of an operating lease to a capital lease by classifying the leased asset as a purchased asset, which is included on the balance sheet as part of the company’s assets.

The Financial Accounting Standards Board (FASB) issued a new Accounting Standards Update (ASU) in 2016 that requires all leases over twelve months to be both capitalized as an asset and recorded as a liability on the lessee’s books, to fairly present both the rights and obligations of the lease.1

Finance

Another aspect of capitalization refers to the company’s capital structure. Capitalization can refer to the book value cost of capital, which is the sum of a company’s long-term debt, stock, and retained earnings. The alternative to the book value is the market value.

The market value cost of capital depends on the price of the company’s stock. It is calculated by multiplying the price of the company’s shares by the number of shares outstanding in the market.

If the total number of shares outstanding is 1 billion and the stock is currently priced at $10, the market capitalization is $10 billion. Companies with a high market capitalization are referred to as large caps.

A company can be overcapitalized or undercapitalized. Undercapitalization occurs when earnings are not enough to cover the cost of capital, such as interest payments to bondholders or dividend payments to shareholders. Overcapitalization occurs when there’s no need for outside capital because profits are high and earnings were underestimated.

Overcapitalization in finance

Overcapitalization is a situation in which actual profits of a company are not sufficient enough to pay interest on debentures, on loans and pay dividends on shares over a period of time. This situation arises when the company raises more capital than required. A part of capital always remains idle. With a result, the rate of return shows a declining trend. The causes can be-

  1. High promotion cost- When a company goes for high promotional expenditure, i.e., making contracts, canvassing, underwriting commission, drafting of documents, etc. and the actual returns are not adequate in proportion to high expenses, the company is over-capitalized in such cases.
  2. Purchase of assets at higher prices- When a company purchases assets at an inflated rate, the result is that the book value of assets is more than the actual returns. This situation gives rise to over-capitalization of company.
  3. A company’s floatation n boom period- At times company has to secure it’s solvency and thereby float in boom periods. That is the time when rate of returns are less as compared to capital employed. This results in actual earnings lowering down and earnings per share declining.
  4. Inadequate provision for depreciation- If the finance manager is unable to provide an adequate rate of depreciation, the result is that inadequate funds are available when the assets have to be replaced or when they become obsolete. New assets have to be purchased at high prices which prove to be expensive.
  5. Liberal dividend policy- When the directors of a company liberally divide the dividends into the shareholders, the result is inadequate retained profits which are very essential for high earnings of the company. The result is deficiency in company. To fill up the deficiency, fresh capital is raised which proves to be a costlier affair and leaves the company to be over- capitalized.
  6. Over-estimation of earnings- When the promoters of the company overestimate the earnings due to inadequate financial planning, the result is that company goes for borrowings which cannot be easily met and capital is not profitably invested. This results in consequent decrease in earnings per share.

Effects of Overcapitalization

 

  1. On Shareholders- The over capitalized companies have following disadvantages to shareholders:
    1. Since the profitability decreases, the rate of earning of shareholders also decreases.
    2. The market price of shares goes down because of low profitability.
    3. The profitability going down has an effect on the shareholders. Their earnings become uncertain.
    4. With the decline in goodwill of the company, share prices decline. As a result shares cannot be marketed in capital market.

     

  2. On Company-
    1. Because of low profitability, reputation of company is lowered.
    2. The company’s shares cannot be easily marketed.
    3. With the decline of earnings of company, goodwill of the company declines and the result is fresh borrowings are difficult to be made because of loss of credibility.
    4. In order to retain the company’s image, the company indulges in malpractices like manipulation of accounts to show high earnings.
    5. The company cuts down it’s expenditure on maintainance, replacement of assets, adequate depreciation, etc.

     

  3. On Public- An overcapitalized company has got many adverse effects on the public:
    1. In order to cover up their earning capacity, the management indulges in tactics like increase in prices or decrease in quality.
    2. Return on capital employed is low. This gives an impression to the public that their financial resources are not utilized properly.
    3. Low earnings of the company affects the credibility of the company as the company is not able to pay it’s creditors on time.
    4. It also has an effect on working conditions and payment of wages and salaries also lessen.

Undercapitalization

An undercapitalized company is one which incurs exceptionally high profits as compared to industry. An undercapitalized company situation arises when the estimated earnings are very low as compared to actual profits. This gives rise to additional funds, additional profits, high goodwill, high earnings and thus the return on capital shows an increasing trend. The causes can be-

  1. Low promotion costs
  2. Purchase of assets at deflated rates
  3. Conservative dividend policy
  4. Floatation of company in depression stage
  5. High efficiency of directors
  6. Adequate provision of depreciation
  7. Large secret reserves are maintained.

Efffects of Under Capitalization

  1. On Shareholders
    1. Company’s profitability increases. As a result, rate of earnings go up.
    2. Market value of share rises.
    3. Financial reputation also increases.
    4. Shareholders can expect a high dividend.

     

  2. On company
    1. With greater earnings, reputation becomes strong.
    2. Higher rate of earnings attract competition in market.
    3. Demand of workers may rise because of high profits.
    4. The high profitability situation affects consumer interest as they think that the company is overcharging on products.

     

  3. On Society
    1. With high earnings, high profitability, high market price of shares, there can be unhealthy speculation in stock market.
    2. ‘Restlessness in general public is developed as they link high profits with high prices of product.
    3. Secret reserves are maintained by the company which can result in paying lower taxes to government.
    4. The general public inculcates high expectations of these companies as these companies can import innovations, high technology and thereby best quality of product.

Market Capitalization

Market capitalization is the aggregate valuation of the company based on its current share price and the total number of outstanding stocks. It is calculated by multiplying the current market price of the company’s share with the total outstanding shares of the company.

Market capitalization is one of the most important characteristics that helps the investor determine the returns and the risk in the share. It also helps the investors choose the stock that can meet their risk and diversification criterion.

For instance, a company has 20 million outstanding shares and the current market price of each share is $100. Market capitalization of this company will be 20 mln x $100 = $2 bln.

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