Module I - Nature of Financial Management

Financial function – meaning, role, scope & importance, Job of a

financial manager. Financial goal. Financial planning – Meaning & steps
in financial planning. Capitalization – Over & under capitalization.

FUNCTIONS OF FINANCE
Finance function is the most important function of a business. Finance is, closely, connected with
Production, Marketing and other activities. In the absence of finance, all these activities come to
a halt. In fact, only with finance, a business activity can be commenced, continued and expanded.
Finance exists everywhere, be it production, marketing, human resource development or
undertaking research activity. Understanding the universality and importance of finance,
finance managers associated, in modern business, in all activities as no activity can exist
without funds. Financial Decisions or Finance Functions are closely inter-connected. All
decisions mostly involve finance. When a decision involves finance, it is a financial decision in a
business firm. In all the following financial areas of decision-making, the role of finance
manager is vital.
The function of raising funds, investing them in assets and distributing returns earned from assets
to shareholders are respectively known as financing, investment and dividend decisions. While
performing these functions, a firm attempts to balance cash inflows and outflows. This is called
liquidity decision, and we may add it to the list of important finance decisions or functions.

“Financial Management deals with procurement of funds and their effective utilisation in the
business” —S.C. Kuchhal

The definition provided by Kuchhal is most acceptable as it focuses, clearly, the Basic
requirements of financial management. From his definition, two basic aspects emerge:
(A) Procurement of funds.
(B) Effective and judicious utilisation of funds.

Financial management has become so important that it has given birth to Financial Management
as a separate subject. Though it was a branch of economics till 1890, as a separate activity or
discipline it is of recent origin. Still, it has no unique body of knowledge of its own, and draws
heavily on economics for its theoretical concepts even today.

We can classify the finance functions or financial decisions into four major groups:
(A) Investment Decision or Long-term Asset mix decision
(B) Finance Decision or Capital mix decision
(C) Liquidity Decision or Short-term asset mix decision
(D) Dividend Decision or Profit allocation decision

(A) Investment Decision

Investment decisions relate to selection of assets in which funds are to be invested by the firm.
Investment alternatives are numerous. Resources are scarce and limited. They have to be
rationed and discretely used. Investment decisions allocate and ration the resources among the
competing investment alternatives or opportunities. The effort is to find out the projects, which
are acceptable.
Investment decisions relate to the total amount of assets to be held and their composition in
the form of fixed and current assets. Both the factors influence the risk the organisation is
exposed to. The more important aspect is how the investors perceive the risk. The investment
decisions result in purchase of assets. Assets can be classified, under two broad categories:
(i) Long-term investment decisions – Long-term assets
(ii) Short-term investment decisions – Short-term assets

Long-term Investment Decisions: The long-term capital decisions are referred to as capital
budgeting decisions, which relate to fixed assets. The fixed assets are long term, in nature.
Basically, fixed assets create earnings to the firm. They give benefit in future. It is difficult to
measure the benefits as future is uncertain.
The investment decision is important not only for setting up new units but also for expansion of
existing units. Decisions related to them are, generally, irreversible. Often, reversal of decisions
results in substantial loss. When a brand new car is sold, even after a day of its purchase, still,
buyer treats the vehicle as a second-hand car. The transaction, invariably, results in heavy loss
for a short period of owning. So, the finance manager has to evaluate profitability of every
investment proposal, carefully, before funds are committed to them.

Short-term Investment Decisions: The short-term investment decisions are, generally, referred
as working capital management. The finance manger has to allocate among cash and cash
equivalents, receivables and inventories. Though these current assets do not, directly, contribute
to the earnings, their existence is necessary for proper, efficient and optimum utilisation of fixed
assets.

(B) Finance Decision

Once investment decision is made, the next step is how to raise finance for the concerned
investment. Finance decision is concerned with the mix or composition of the sources of
raising the funds required by the firm. In other words, it is related to the pattern of
financing. In finance decision, the finance manager is required to determine the proportion of
equity and debt, which is known as capital structure. There are two main sources of funds,
shareholders‟ funds (variable in the form of dividend) and borrowed funds (fixed interest-
bearing). These sources have their own peculiar characteristics. The key distinction lies in the
fixed commitment. Borrowed funds are to be paid interest, irrespective of the profitability of the
firm. Interest has to be paid, even if the firm incurs loss and this permanent obligation is not
there with the funds raised from the shareholders. The borrowed funds are relatively cheaper
compared to shareholders’ funds, however they carry risk. This risk is known as financial
risk i.e. Risk of insolvency due to non-payment of interest or non-repayment of borrowed capital.
On the other hand, the shareholders’ funds are permanent source to the firm. The
shareholders‟ funds could be from equity shareholders or preference shareholders. Equity share
capital is not repayable and does not have fixed commitment in the form of dividend. However,
preference share capital has a fixed commitment, in the form of dividend and is redeemable, if
they are redeemable preference shares.
Barring a few exceptions, every firm tries to employ both borrowed funds and shareholders‟
funds to finance its activities. The employment of these funds, in combination, is known as
financial leverage. Financial leverage provides profitability, but carries risk. Without risk, there
is no return. This is the case in every walk of life! When the return on capital employed
(equity and borrowed funds) is greater than the rate of interest paid on the debt,
shareholders’ return get magnified or increased. In period of inflation, this would be
advantageous while it is a disadvantage or curse in times of recession.

Return on equity (ignoring tax) is 20%, which is at the expense of debt as they get 7% interest
only.
In the normal course, equity would get a return of 15%. But they are enjoying 20% due to
financing by a combination of debt and equity.
The finance manager follows that combination of raising funds which is optimal mix of debt and
equity. The optimal mix minimises the risk and maximises the wealth of shareholders.

(C) Liquidity Decision

Liquidity decision is concerned with the management of current assets. Basically, this is
Working Capital Management. Working Capital Management is concerned with the
management of current assets. It is concerned with short-term survival. Short term-survival is a
prerequisite for long-term survival.
When more funds are tied up in current assets, the firm would enjoy greater liquidity. In
consequence, the firm would not experience any difficulty in making payment of debts, as and
when they fall due. With excess liquidity, there would be no default in payments. So, there
would be no threat of insolvency for failure of payments. However, funds have economic cost.
Idle current assets do not earn anything. Higher liquidity is at the cost of profitability.
Profitability would suffer with more idle funds. Investment in current assets affects the
profitability, liquidity and risk. A proper balance must be maintained between liquidity and
profitability of the firm. This is the key area where finance manager has to play significant
role. The strategy is in ensuring a trade-off between liquidity and profitability. This is,
indeed, a balancing act and continuous process. It is a continuous process as the conditions and
requirements of business change, time to time. In accordance with the requirements of the firm,
the liquidity has to vary and in consequence, the profitability changes. This is the major
dimension of liquidity decision working capital management. Working capital management is
day to day problem to the finance manager. His skills of financial management are put to test,
daily.

(D) Dividend Decision

Dividend decision is concerned with the amount of profits to be distributed and retained in the
firm.
Dividend: The term „dividend‟ relates to the portion of profit, which is distributed to
shareholders of the company. It is a reward or compensation to them for their investment made
in the firm. The dividend can be declared from the current profits or accumulated profits. Which
course should be followed – dividend or retention? Normally, companies distribute certain
amount in the form of dividend, in a stable manner, to meet the expectations of shareholders and
balance is retained within the organisation for expansion. If dividend is not distributed, there
would be great dissatisfaction to the shareholders. Non-declaration of dividend affects the
market price of equity shares, severely. One significant element in the dividend decision is,
therefore, the dividend payout ratio i.e. what proportion of dividend is to be paid to the
shareholders. The dividend decision depends on the preference of the equity shareholders
and investment opportunities, available within the firm. A higher rate of dividend, beyond
the market expectations, increases the market price of shares. However, it leaves a small amount
in the form of retained earnings for expansion. The business that reinvests less will tend to grow
slower. The other alternative is to raise funds in the market for expansion. It is not a desirable
decision to retain all the profits for expansion, without distributing any amount in the form of
dividend. There is no ready-made answer, how much is to be distributed and what portion is to
be retained. Retention of profit is related to
• Reinvestment opportunities available to the firm.
• Alternative rate of return available to equity shareholders, if they invest themselves.

ROLE OF FINANCE MANAGER

The finance manager handles finance. The role of finance manager is pivotal. He can change the
fortunes of the organisation with proper planning, monitoring and timely guidance. Equally, if
the manager is not competent, even a profitable organisation may dwindle or even sink. The
finance manger is, now, responsible in shaping the fortunes of the enterprise. The role of finance
manager, in a modern business, is pervasive in all the activities of business firm, including
production and marketing.
It has been rightly said, money begets money. Business needs money to make more money.
However, business can make money, when it is properly managed. The financial history is
replete with stories how even the profitable organisations were wound up, when the management
of finance had turned bad due to mismanagement of financial affairs.
It is misunderstood, in some corners, that the role of finance manager is important only in private
organisations. It is not so. His role is important, both in private and public sector. He has a
positive role to play in every type of organisation. Even in non-profit making organisations, his
role exists as long as there is involvement of funds.
Influences Fortunes of Firm: The history of failures of organisations is interesting. Many
firms have failed, not because of inefficiency of production, inability in marketing or non-
availability of funds but due to the absence of competent finance manager. In many public
sector undertakings, in particular, state government undertakings, importance is given to the
appointment of peons, more than adequately, but not to the appointment of competent
professional manager in finance, even after lapse of several years. That is the real secret of
numerous loss making organisations, in public sector! Over the years, the picture has been
changing, but only after the real damage has already occurred in those public sector
undertakings, due to the non appointment of professional finance managers, at the time of
formation of those undertakings.
In several public sector undertakings, the presence of competent finance manager is often found
inconvenient. A finance manager cannot play any significant role in the public sector, unless he
is allowed to play.
Exists Everywhere: The role of finance manager, in modern times, can be well said to be
universal and pervasive. Hardly, we find any activity, which does not involve finance. Even
entertainment in a firm requires financial management due to financial implications. In modern
business, no decision is taken without the consultation of finance. Even in recruitment, the
presence of finance representative has been a normal feature manager. Only the level of finance
representative changes, dependent upon the status of position for which recruitment is held. At
times, people working in other departments feel that the finance manager has been interfering in
all matters, unconnected to him. It is due to inadequate understanding of the role and
expectations expected of him in modern business. The finance manager can, definitely,
contribute to the overall development of the organisation provided he is competent and allowed
to perform his functions, independently.

IMPORTANCE OF FINANCIAL MANAGEMENT

Finance is the lifeblood of business organization. It needs to meet the requirement of the
business concern. Each and every business concern must maintain adequate amount of
finance for their smooth running of the business concern and also maintain the business
carefully to achieve the goal of the business concern. The business goal can be achieved only
with the help of effective management of finance. We can‟t neglect the importance of finance at
any time and at any situation. Some of the importance of the financial management is as follows:

(i) Financial Planning: Financial management helps to determine the financial requirement
of the business concern and leads to take financial planning of the concern. Financial planning is
an important part of the business concern, which helps to promotion of an enterprise.

(ii) Acquisition of Funds: Financial management involves the acquisition of required finance to
the business concern. Acquiring needed funds play a major part of the financial management,
which involve procuring funds from all possible source of finance at minimum cost.
(iii) Proper Use of Funds: Proper use and allocation of funds leads to improve the operational
efficiency of the business concern. When the finance manager uses the funds properly, they can
reduce the cost of capital and increase the value of the firm.

(iv) Financial Decision: Financial management helps to take sound financial decision in the
business concern. Financial decision will affect the entire business operation of the concern.
Because there is a direct relationship with various department functions such as marketing,
production personnel, etc.

(v) Improve Profitability: Profitability of the concern purely depends on the effectiveness and
proper utilization of funds by the business concern. Financial management helps to improve the
profitability position of the concern with the help of strong financial control devices such as
budgetary control, ratio analysis and cost volume profit analysis.

(vi) Increase the Value of the Firm: Financial management is very important in the field of
increasing the wealth of the investors and the business concern. Ultimate aim of any business
concern will achieve the maximum profit and higher profitability leads to maximize the
wealth of the investors as well as the nation.

(vii) Promoting Savings: Savings are possible only when the business concern earns higher
profitability and maximizing wealth. Effective financial management helps to promoting and
mobilizing individual and corporate savings. Nowadays financial management is also
popularly known as business finance or corporate finances. The business concern or
corporate sectors cannot function without realizing the importance of the financial management.
 Objectives of Finance Function
For optimum financial decisions, the objectives of financial management shall be clearly defined.
They should be so laid down that they contribute directly towards the achievement of overall
business objectives. Objectives provide a normative framework within which a firm is to take
decisions. Financing is the functional area of objective of the business and contribute directly
towards it. The main objectives of a business are survival and growth. In order to survive ups
and downs in the business, the business must earn sufficient profits and it should also maintain
proper relations with shareholders, customers, suppliers and other social groups. The financial
management of an organisation must seek to achieve the following objectives:

 To ensure adequate and regular supply of FUNDS.

 To provide a fair rate of return to the suppliers of capital viz. shareholders.
 To ensure effective utilization of FUNDS by maintaining proper balance between
profitability, liquidity and safety.
 To generate and build up sufficient surplus for expansion and growth through ploughing
back of profits.
 To minimize cost of capital by developing a sound capital between various securities issued
by the company.
 To coordinate the activities of the finance department with the activities of other
departments in the organisation.

Scope of Financial Management

The finance department of an enterprise performs several functions in order to achieve the above
objectives. The scope of finance function is very wide. It consists of the following activities:

(i) Estimating the Requirement of Funds:

The finance department must estimate the capital requirements of the firm accurately for long
term and short term needs. In estimating the capital requirements of the business, the finance
department must take help of the budgets of various activities of the business e.g. sales budget,
production budget, expenses budget etc. prepared by the concerned departments. In the initial
stage, the estimate is done by promoters but in a growing concern, it is done by the finance
department. Unless the FINANCIAL forecast is correct, business is likely to run into
difficulties due to excess or shortage of FUNDS Correct estimates ensure the availability of
FUNDS as and when they are needed. In estimating the requirement of funds, nature and size of
the business, modernization and expansion plan should be given due consideration.

(ii) Determining the Capital Structure:

By capital structure we mean the kind and proportion of different securities for raising the
required funds. Once the total requirement of funds is determined, a decision regarding the type
of securities to be issued and the relative proportion between them is to be taken. The finance
department must determine the proper mix of debt and equity. It should also decide the ratio
between long term and short term debts. In determining these ratios, cost of raising finance
from different sources, period for which funds are required and several other factors should be
considered. A proper balance between risk and returns should be maintained.

(iii) Choice of Sources of Finance:

A company can raise funds from different sources e.g. shareholders, debenture holders,
banks, financial institutions, public deposits etc. Before raising the funds, it has to decide the
source from which the funds are to be raised. The choice of the source of finance should be made
very carefully by taking a number of factors into account such as cost of raising funds,
conditions attached, charge on assets, burden of fixed charges, dilution of ownership and
control etc. For example, if the company does not want to dilute the ownership, it will depend
on any source of finance other than investment in shares.

(iv) Investment of Funds:

The FUNDS raised from different sources should be prudently invested in various assets: short
term as well as long term to optimize the return on investment. In taking decisions for the
investment of long term funds, a careful assessment of various alternatives should be made
through capital budgeting, opportunity cost analysis and many other techniques used to
evaluate the investment proposals. A part of the long term funds should be invested in working
capital of the company. While taking decision for the investment of funds in long term assets,
management should be guided by three basic principles, viz. safety, profitability and
liquidity. In taking decisions for the investment of funds in working capital, the finance manager
must seek cooperation of marketing and production departments in estimating the funds which
are to be involved in carrying of inventories in finished product and credit policy of the
marketing department and in raw material and factory supplies of the production department.

(v) Management of Cash:

It is the prime responsibility of the finance manager to see that an adequate supply of cash is
available at proper time for the smooth running of the business. Cash is needed to purchase raw
materials, pay off creditors, to pay to workers and to meet the day to day expenses of the
business. Availability of cash is necessary to maintain liquidity and credit- worthiness of the
business. Excess cash must be avoided as it costs money. If there is any cash in excess, it
should be invested in near cash assets such as INVESTMENTS etc. which may be converted
into cash within no time. A cash flow statement should be prepared by the department to know
the correct need of cash is essential to achieve the goal of profitability and liquidity. The finance
manager should decide in advance how much cash he should retain to meet current obligations of
the company.
 (vi) Disposal of Surplus:
One of the prime functions of the finance department is to allocate the surplus. After paying all
taxes, the available surplus of the business can be allocated for three purposes: (a) for
paying dividend to the shareholders as a return on their investment, (b) for distributing
bonus to workmen and company's contribution to other profit sharing plans, and (c) for
ploughing back of profits for the expansion of business. As far as the second alternative is
concerned, the amount to be paid to workers is generally fixed either by statute or by agreement
and therefore, there is no problem in allocating surplus for this purpose. But a considerable,
attention is to be paid in so far as first and third alternatives are concerned i.e., how much to be
paid to shareholders as dividend and how much to be retained in the business. For this purpose
factors like the trend of the earning of the company, trend of the market price of its shares; the
requirement of funds for the purpose of expansion and future prospects should be considered.

Job of a Financial Manager:

A financial manager is responsible for providing financial advice and support to colleagues
and clients to enable them to make sound business decisions. The role of the financial manager is
more than simply accounting; it is multifunctional. Financial managers must understand all
aspects of the business so that they are able to adequately advise and support the chief executive
officer in decision-making and ensuring company growth and profitability. Almost every
firm, government agency, or other type of organization has one or more financial managers.
Financial managers oversee the preparation of financial reports, direct investment
activities, and implement cash management strategies. They also implement the long-term
goals of their organization. Many corporations operate multifunctional teams where the financial
manager is responsible for a particular division or function, or looks after a range of departments
and functions.

A financial manager is a person who takes care of all the important financial functions of an
organization. The person in charge should maintain a far sightedness in order to ensure that the
funds are utilized in the most efficient manner. His actions directly affect the Profitability,
growth and goodwill of the firm.

Following are the main functions of a Financial Manager:

1. Raising of Funds:

In order to meet the obligation of the business it is important to have enough cash and liquidity.
A firm can raise funds by the way of equity and debt. It is the responsibility of a financial
manager to decide the ratio between debt and equity. It is important to maintain a good balance
between equity and debt.
2. Allocation of Funds:
Once the funds are raised through different channels the next important function is to allocate
the funds. The funds should be allocated in such a manner that they are optimally used. In order
to allocate funds in the best possible manner the following point must be considered

 The size of the firm and its growth capability

 Status of assets whether they are long-term or short-term
 Mode by which the funds are raised

These financial decisions directly and indirectly influence other managerial activities. Hence
formation of a good asset mix and proper allocation of funds is one of the most important
activity

3. Profit Planning

Profit earning is one of the prime functions of any business organization. Profit earning is
important for survival and sustenance of any organization. Profit planning refers to proper usage
of the profit generated by the firm.

Profit arises due to many factors such as pricing, industry competition, state of the economy,
mechanism of demand and supply, cost and output. A healthy mix of variable and fixed factors
of production can lead to an increase in the profitability of the firm.

Fixed costs are incurred by the use of fixed factors of production such as land and machinery. In
order to maintain a tandem it is important to continuously value the depreciation cost of fixed
cost of production. An opportunity cost must be calculated in order to replace those factors of
production which has gone thrown wear and tear. If this is not noted then these fixed cost can
cause huge fluctuations in profit.

4. Understanding Capital Markets

Shares of a company are traded on stock exchange and there is a continuous sale and purchase
of securities. Hence a clear understanding of capital market is an important function of a
financial manager. When securities are traded on stock market there involves a huge amount of
risk involved. Therefore a financial manger understands and calculates the risk involved in this
trading of shares and debentures.

It‟s on the discretion of a financial manager as to how to distribute the profits. Many investors
do not like the firm to distribute the profits amongst shareholders as dividend instead invests in
the business itself to enhance growth. The practices of a financial manager directly impact the
operation in capital market.

5. Management of Cash:
Management of cash and other current assets is an important task of financial manager. It
involves forecasting the cash inflows and outflows to ensure that there is neither shortage nor
surplus of cash with the firm. Sufficient funds must be available for purchase of materials,
payment of wages and meeting day-to-day expenses.
6. Financial Control:
Evaluation of financial performance is also an important function of financial manager. The
overall measure of evaluation is Return on Investment (ROI). The other techniques of financial
control and evaluation include budgetary control, cost control, internal audit, break-even analysis
and ratio analysis. The financial manager must lay emphasis on financial planning as well.

7. Deal with mergers and acquisitions:

When a company takes over the other company or merger of two companies take place there is a
huge financial investment required for the same. The merger and acquisitions may sometimes
turn out to be counterproductive and result in huge financial losses. So to check such a situation
the financial managers has to evaluate the situation well and advice the management for
making well informed decisions.

8. Manage associated risks:

Both the procurement and investment of finance involves great risk as the decision are strategic
and the future of the organization lies mainly on them. The financial managers
have to evaluate the various risks that are associated so that the risk can be
minimized and helps in achieving the organizational goals.

The financial manager‟s role, particularly in business, is changing in response to technological

advances that have significantly reduced the time it takes to produce financial reports. Financial
managers now perform more data analysis to offer senior management ideas on how to
maximize profits. They play an increasingly significant role in mergers and acquisitions and in
related financing, and in areas that require wide-ranging, focused knowledge to diminish risks
and maximize profit.

Financial Goals:
The monetary objectives of an individual or organization that are often determined by their
future requirements for funds. For a business, its financial goals can be expressed as part of an
overall FINANCIAL plan that might include profit targets, projected borrowing requirements,
covering operating expenses, and developing a debt payback schedule. Every organization or
business will have financial goals. These goals are mainly determined by their future
requirements for FUNDS. It’s often part of an overall financial plan that includes profit targets,
borrowing projections, managing operating expenses like salaries or raw material costs,
minimizing taxes and a schedule for paying back any debt.
Financial Planning:
Planning is a systematic way of deciding about and doing things in a purposeful manner. When
this approach is applied exclusively for financial matter, it is termed as financial planning. In
connection with any business enterprise, it refers to the process of estimating a firm’s financial
requirements and determining pattern of financing. It includes determining the objectives,
policies, procedures and programs to deal with financial activities. Thus, financial planning
involves:

a. Determining capital requirements- This will depend upon factors like cost of current
and fixed assets, promotional expenses and long- range planning. Capital requirements
have to be looked with both aspects: short- term and long- term requirements.
b. Determining capital structure- The capital structure is the composition of capital, i.e.,
the relative kind and proportion of capital required in the business. This includes
decisions of debt- equity ratio- both short-term and long- term.
c. Framing financial policies with regards to cash control, lending, borrowings, etc.
d. A finance manager ensures that the scarce financial resources are maximally utilized
in the best possible manner at least cost in order to get maximum returns on investment.

CAPITIALISATION
Capitalization is one of the most important parts of financial decision, which is related to the
total amount of capital employed in the business concern. Capitalization refers to the process of
determining the quantum of funds that a firm needs to run its business. Capitalization is only
the par value of share capital and debenture and it does not include reserve and surplus. In the
context of financial planning however, it refers to the process of determining the amount of
capital required by a company.

The capital estimation is arrived at by using the following two theories.

(a) Cost theory; and
(b) Earning theory.

Let us have a brief about these two theories.

(a) Cost Theory: According to the cost theory of capitalisation, the amount of capital required
by the company is calculated by adding up the cost of its fixed CAPITIALISATION. The
term capitalisation has various connotations. In common parlance, it refers to the amount at
which a company is valued based on its capital employed. Some of the experts on finance used
this concept in a narrower sense and defined it as the par value of a company’s shares and
debentures, while some of them interpreted it as the par value of its total long-term funds
which includes owners fund, borrowed funds, reserves and surplus earnings. In the context
of financial planning however, it refers to the process of determining the amount of capital
required by a company. The cost of its fixed assets, the amount of its working capital and the
cost of establishing the business. This approach is simple and used widely in case of new
companies.

(b) Earning Theory: According to earning theory, the capital requirement of a company is
calculated on the basis of the capitalised value of its earning. For example, if the average
annual earning of a company is Rs. 5 lakh and the normal rate of return on the capital employed
in case of companies in the same industry is 10%, then the amount of capitalisation is Rs. 50
lakh. For a new company the amount of capitalisation is calculated on the basis of its
estimated earnings. For example, if a new company expects to earn an average annual income
of Rs. 3 lakh and the normal rate of return of the industry is 5%, then the amount of
capitalisation or the quantum of fund it would require to run the business is Rs. 60 lakh. This
approach of capitalisation is considered more rational and relevant because it helps in
evaluating as to how far the actual capital employed is justified by the earning of the company.

If the actual rate of return is same as the normal rate of return then it is said to be proper
capitalised. But in real sense, a company may be either over-capitalised or under-capitalised that
means the actual rate of return may be less or more than the normal rate of return. Let us know in
detail about the concept of over-capitalisation and under-capitalisation as discussed below:

OVER-CAPITALISATION
A company is said to be over-capitalised if its capital employed is more than its proper
capitalisation. For example, if a company‟s average annual earnings is Rs.2,00,000 and the
normal rate of return is 10%. Then its proper capitalisation is Rs.20,00,000. Now, if the actual
capital employed (total long term funds) is Rs.25,00,000 it will be treated as over-capitalised.
You can also put it in another simpler way i.e, if a company‟s actual rate of earnings is less
than the normal rate of return, it is treated as a case of over-capitalisation. In the above
example, the company‟s actual rate of earnings works out as 8%, which is less than the normal
rate of return i.e., 10%. So, it is considered as over-capitalised and the company is not in a
position to pay interest and dividends at a fair rate. Such a situation may be caused by the
following factors:

(a) Excessively high price paid for the purchase of goodwill and other fixed assets.
(b) Underutilisation of production capacity.
(c) Raising more capital in the form of shares and debentures than required.
(d) Liberal dividend policy.
(e) Higher rate of corporate taxation.
(f) Underestimation of capitalisation rate or overestimation of earnings while deciding on the
amount of capital to be raised.
Over-capitalisation is not desirable in the long run interest of the shareholders and the
company. It leads to lower rate of dividend, reduction in the market value of shares and
difficulty in raising more funds. Hence, there is need to rectify such situation as quickly as
possible by reducing debt, efficient utilisation of assets, and by following a conservative
dividend policy.

UNDER-CAPITALISATION
Under-capitalisation is just the reverse of over-capitalisation. In other words, a company is said
to be under-capitalised if its capital employed is less than its proper capitalization i.e., the
amount of capital invested is not justified by its annual earnings. In the earlier case, for example,
if the company‟s actual capital employed is Rs. 16,00,000 it shall be treated as under-capitalised
as it is less than Rs. 20,00,000, the proper capitalisation. Alternatively, if a company‟s actual
rate of earnings is more than the normal rate of return, it is treated as a case of under-
capitalisation. This does not imply that the company suffers from inadequacy of capital. In fact,
such a situation may be the result of underestimation of expected earnings while deciding on the
amount of capital to be raised or using low capitalisation rate for the purpose or by following a
conservative dividend policy. Of course, improvement in earnings can also be the result of cost
reduction exercise or high efficiency. Thus, under-capitalisation is indicative of a sound
financial position and may lead to increase in the market value of company’s shares.
However, it can encourage competition as high rate of return may attract new entrants in the
field. The workers of the company may demand for higher wages and other benefits. When
the company earns more profit, the customers may feel that they are being over-charged by the
company. So, it is better to take corrective steps like capitalisation of profits (issue bonus shares)
or splitting up of the shares (a share of Rs.10 may be converted into five shares of Rs. 2 each).
Although under-capitlisation is considered a lesser evil than over-capitalisation (as the situation
can be remedied more quickly) it is better to ensure a fair or proper capitalisation.