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A brief discussion on Under-Capitalization
When owing to a miscalculated financial planning, the estimated earnings of a company are far surpassed by the actual profits; it gives rise to the situation of under-capitalization. An under-capitalized company earns exceptionally high profits compared to the rest of the industry and this contributes to high goodwill, additional funds, and higher earnings. Consequently, the return on capital displays an increasing trend.
The common causes that can be the reason behind under-capitalization are:
- Low spending on the promotions.
- Keeping the dividend-sharing policy conservative.
- Sufficient provision for depreciation in the financial plan.
- Maintaining secret reserves to meet crisis.
- Purchase of assets at a price where the book value will be lower than the returns.
As the rate of earnings goes up, under-capitalization has certain effects on shareholders as well as the company. The market value of the shares increase and the shareholders can also expect increased dividends. The company’s financial reputation becomes better but this also attracts competition. It may have a negative impact on the consumers’ mind who may think that the company is overcharging its products. The overall stock market speculation can be unhealthy. The secret reserves can be interpreted as a result of defaulting tax payments. The consumers’ expectation from the company increases.
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