Capitalization – Concept, Definitions, Importance, Overcapitalization, Undercapitalization & more
After learning the capital structure, you must be curious to know about Capitalization in finance.
Well, then you are on the right space as, under this guide you can find almost everything related to Capitalization.
Before learning more in detail, it is good to learn some basics. You can say Capitalization is nothing but the total value of the company.
It is way more than just a measure, but investors mainly use this to enhance and determine the value of the company.
On the flip side, financial experts use the capital amount under business ownership as per their own methods.
If you use more than one way for a valuation, then some issues like market crash might come up.
The main agenda of almost all businesses is to maximize the value of the company. Here both the finance manager and individual investors want to learn about the value that a business creates.
Capitalization and business value are mostly related. In all the phases of the business cycle, the company mainly needs to raise capital.
One of the most critical areas of financial management is Capitalization.
What is Capital?
Before you learn about Capitalization, you must know something about capital. Under finance, we say capital is the money that investors need for investment or project.
Instead, economists say that wealth is one of the most essential elements of the production process. Besides labor, capital is one of the two crucial factors of production.
For example, if a company manufactures a car, then its worth will be the machinery required for car production. But land and labor don’t form a part of the company’s capital.
Besides that, everything is part of the capital in the company, even the company’s offices, desks, telephones, and chairs.
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Know about Capitalization
Now comes the topic you are waiting to know about, that is Capitalization. In simple terms, you can say Capitalization is the method under which cost is integrated with the value of the asset.
Then it is expensed over the asset’s useful life instead of being expensed over the cost period incurred.
Under finance, Capitalization is all about the cost of capital. It is basically in the form of the company’s stock, retained earnings, and long-term debts.
Additionally, market capitalization means the number of outstanding shares of a company in multiplication with the current share price.
You can say Capitalization is the total valuation of the business. The total includes both owned and borrowed capital.
In simple terms, it is the valuation of long term funds which is invested in the company.
You can say it is the manner in which the company distributes its long term obligations between owners and creditors.
In the broader meaning, you can tell the total amount of funds invested in the business. It can include borrowed funds, own funds, surplus earnings, and long term loans.
Symbolization = Share Capital + Debenture + Long term borrowing + Reserve + Surplus earnings.
In the business world, Capitalization has mainly two meanings. One is market capitalization, which is the value of outstanding shares of the company.
Formula for Market Capitalization
The formula is Market Capitalization = Current Stock Price x Shares Outstanding.
But you need to know that the market cap is way different than the equity value. It is also not equal to the debt of the company, along with the equity of the shareholders.
The other meaning is that the term is linked to accounting act for a cost as an asset rather than an expense.
As per GAAP, all the costs that benefit more than one accounting period need to be capitalized.
It is constant with the matching principle because both incomes and expenditures are matched under the accounting period.
Capitalization features share capital, free reserves, debentures, etc. It represents a permanent investment in firms.
Furthermore, it doesn’t include long term loans. You can differentiate it from the capital structure.
You can say that Capitalization is not a broad aspect as it only takes into account the quantitative part.
Definitions of Capitalization in Finance
As per Guthmami and Dougall, Capitalization is the sum of the par value of the outstanding stocks and the bonds.
As per Walker and Baughen, Capitalization refers only to long-term debt and capital stock, and short-term creditors do not constitute suppliers of capital, which is erroneous. In reality, total capital is furnished by short-term creditors and long-term creditors’.
Thus, you can say Capitalization is the value of stocks, and the par value of obligations then defines the par value. The firm distributes it over different types of assets, debentures, and bonds.
Meaning of Capitalization in Finance
Ideally, Capitalization basically has two meanings that are finance and accounting. Under accounting, Capitalization is rule based accounting.
You can use it to recognize the cash outlay as an asset under the balance sheet. Instead, it is an expense under the income statement.
On the other hand, in finance, capitalization is a quantitative element of the capital structure of the firm.
For instance, you can assume there is a company ABC featuring 10 million shares that are outstanding. The current share price is $10.
Based on the formula and these details, we can calculate ABC’s market capitalization is 10 million * 10 = $1 billion. Companies that feature less than $1 billion are known as small cap companies.
On the other hand, companies that feature $ 8billion and more are known as large cap companies.
Secondly, the second user can assume that company ABC makes a new drainage system. It is mainly to avoid run-off rain water from flooding the neighbor’s place.
As cost associated with the drainage are all about an extension to the property. It allows people to use it as a consistent value. Then the company ABC can capitalize on those costs.
So, rather than recording the fees and expenses on the balance sheet, you can record the price as an asset under the balance sheet.
When you register it as an expense, then it will minimize the net income of the company. On the other hand, when the assets depreciate, then it doesn’t have much impact on the profits.
Importance of Capitalization
Ideally, Capitalization represents the theoretical value of the firm. Usually, you can’t do the same for an average merger transaction.
The only reason for this is changes in management, the value of material nonpublic details, some other intangible elements. But you can’t see it in the price of the share or the financial statements.
As per accounting terms, Capitalization is fantastic for companies that wish to keep the net income maximum. But it is not ideal for companies who want to pay minimum taxes.
Capitalization in Finance
Under finance, Capitalization of finance is the total sum of debt and equity of the company.
The Capitalization is all about capital, which is invested in the firm. It can include bonds and stocks.
You can say market capitalization is also the book value cost of the capital. Indirectly it is the total of long term debt, retained earnings, and stock. Market value is the alternative to the book value.
Ideally, the market value cost of capital mainly depends upon the stock price of the company.
You can calculate it by multiplying the current price of the share with the outstanding shares in the market.
Companies that have high market capitalization are most likely large cap, while companies with mid and small Capitalization are midcap and small cap companies.
It is quite possible that the market will be overcapitalized or undercapitalized.
Capitalization in Accounting
Under accounting, Capitalization is all about recording costs as assets under the balance sheet rather than expenses on the income statement.
A company is most likely to record the purchase price of the asset and the acquisition cost of the asset, including transportation.
Additionally, you can say Capitalization in accounting is all about transferring an off-balance sheet operating lease on the balance sheet. They mostly record it as a capital lease.
You can do this by calculating the current value of future operating lease payments. Additionally, you can record the amount on the balance sheet under the asset featuring a corresponding liability.
Under accounting, the principle needs to record the expenses in the ongoing accounting period under which the revenue takes place.
For instance, the supplies in the office are ideally expensed in the occurrence period. It is because the manager expects that people will consume in that specific period only.
But some equipment offer benefits for more than a year to the company. You can say that these items are fixed assets, including cars, computers, office buildings, and others.
You can’t expense the capitalize assets against total earnings in the current accounting period.
Depending on the type of property, plant, or equipment a company can buy, but it can expense over a more extended period of time.
As people use the asset over time to make money for the company under each period, the cost portion is allocated. You can say that the process is depreciation or amortization.
“Capitalization is the conversion of an operating lease to a capital lease for the leased asset”
You can do it by classifying the leased equipment as a purchased asset and include it under the balance sheet as the company’s assets.
In 2016, the Financial Accounting Standards Board (FASB) issued a new Accounting Standards Update. Under this, leases that are for more than a year need to be capitalized both as an asset or liability.
Ideally, the company tends to set the capitalization thresholds. If it is feasible, the cash outlay beyond that will be capitalized.
It is mainly because if it is appropriate, the cash amount is most likely to get capitalized.
The companies are most likely to set their own capitalization threshold because materiality tends to vary vastly from company to company.
You can easily manipulate the financial statements if the cost is capitalized wrongly for the expense.
The net income is most likely to be lower as compared to the standard one if the price is expensed wrongly, in the current period, then the company will also pay fewer taxes.
The net income is most likely to be higher if the cost incurred is incorrectly capitalized. Additionally, assets are most likely to be overstated.
Know about Overcapitalization
Under this situation, the current profits of the firm are not enough to pay off the interest on loans, debentures, etc., over a period.
The case is most likely to come up when a company raises capital in excess. Here the part of the company is idle, and the rate of return is always in a reducing trend. Reasons for overcapitalization are:
High promotion cost – When the company goes for high expenditure, that is canvassing, drafting of documents, etc. The actual returns are not enough to meet the current expenses.
Buying assets at a higher price – If the company buys assets during inflation, the result of the asset’s book value is higher than actual returns.
Here the situation gives rise to the overcapitalization of the firm.
Overestimation of earnings – Thanks to the inadequate financial planning, then the promoters of the business draft wrong earnings.
The result here is, what the firm plans to borrow can’t meet quickly. It results in constant decreases in earnings per share.
Know about Undercapitalization
The situation arises when the company earns high profits as compared to the entire industry.
The undercapitalized company is most likely to occur when estimated earnings are way lower than actual profits.
It gives rise to extra funds, profits, high earnings, and additional goodwill, etc. Hence you can see an increasing trend in capital shows.
The causes of undercapitalization are:
- Minimum promotion costs
- Buying of assets at deflated rates
- High efficiency of directors.
- Enough provision of depreciation
Capitalization – Conclusion
Under accounting, Capitalization takes place when the cost is integrated into the value of the asset. On the other hand, under finance, capitalization is the total value of the company’s equity and debt.
Market capitalization is also the dollar value of the outstanding value of the shares. Hence, the value of securities is the Capitalization.
There are different types of theories of Capitalization, including cost theory and earning theory.
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