Difference between overtrading and overcapitalization


Learning objective:
What is the Difference between overtrading and overcapitalization?

Definitions and meanings

Overtrading:

Overtrading is an accounting term used to describe a situation where a business entity engages in business activities more than it can actively support from its available funds. This shortage of available funds occurs due to increased capital rationing which results in undercapitalization.

Overcapitalization:

When the net worth of share and debt capitals exceeds the value of the assets of a company, the company is said to be as overcapitalized. Overcapitalization usually occurs due to mismanagement of long-term funds available to a company.

Difference between over trading and overcapitalization

The main points of difference between overtrading and overcapitalization are given below:

1. Impact on entity:

Overcapitalization is a situation where market value of a company is less than the long term capitalization of that company. Due to these surged capitals the company is likely to pay more interests and dividend payments than it actually should be paying. Overtrading is a situation where the management of a company increases its business activities without injecting further capital (mostly ignoring working capital) into the business. This results in short term liquidity problems for the business.

2. Working capital management:

Every company needs funds to finance its working capital. In a scenario of over capitalization the amount of available working capital in a company is too high. This indicates that a portion of long term (equity and debt) capital is stuck into the working capital which exceeds its required needs for present business activities and company bears opportunity costs on these over invested funds. On the other hand, overtrading results in a decrease of levels of working capital of a business. This does not mean that the current working capital is depleted rather business is somehow unable to fund the expansion of its operations. This scenario may lead to poor management of receivables, payables and inventory cycles.

3. Future trading:

Overcapitalization can reduce the overall earnings of a company. This is because, long term funds are thrust into financing working capital unnecessarily which could have actively been invested in trading activates of the company. This not only reduces profits in terms of additional payments for cost of equity and debt but also reduces the level of retained earnings of the company. Overtrading is the increase of business activities more than its available capacity because these activities are not appropriately funded. Due to these reasons such expansions do not remain sustainable.

4. Fund management:

A company facing overcapitalization experiences difficulties in managing its funds effectively. The main reason behind this is that a specific part of available long term funds of the company is invested into day to day operational management of the company. This means that the net current assets are way to higher than the available needs of the company which puts a restraint to deploy those funds into newer investment opportunities. A company facing overtrading can face a lack of funds due to capital rationing which is the restriction on available funds to an entity.

5. Debt capacity:

The debt capacity of a company experiencing overcapitalization is reduced due to mismanagement of long term investments because the company would have borrowed more than it needs to sustain its operations without investing that capital into value adding trading activities. However, a company facing overtrading faces a shortfall of available finance due to which it either has no debt capacity or it cannot utilize its debt capacity due to internal or external restrictions.

6. Effective rate of return:

It is very likely that an overcapitalization may occur due to the overstated book values of its acquired assets. This impact may arise if the assets are bought at a price more than their par value or fair value, or the depreciation policies of a company do not match the systematic devaluation requirements of the assets. This scenario will ultimately result in the loss of revenues for the company in real terms as it would decrease the rate of return for the company. However, overtrading results in effective rates of returns being maintained or surged, but with increased going concern risks for the business. Until and unless these activities are supported by required levels of incremental capitals these return do not sustain.

Overtrading vs Overcapitalization
Impact on entity
Entity has to face short term cash flow issues due to lack of capital especially working capital. Entity has to bear increased cost of funds unnecessarily.
Working capital management
Working capital is less than needed. Working capital is more than needed.
Future trading
Company cannot invest in future projects due to capital rationing. Company has over invested into current projects.
Fund management
Funds are restricted but over employed in business activities with increased risks. Funds are available but poorly managed.
Debt Capacity
The debt capacity is almost nil and do not have enough available resources to fund business activities. Has enough funds available which are mismanaged due to which debt capacity can reduce.
Effective rate of return
The effective rate of return remains the same or increases. The effective rate or return is lower if compared to companies with effective capitalization.

Conclusion:

The efficacious management of capital of a business is a big challenge for the management of a company. Long term capitals are raised from two primary sources. One is the equity capital which is raised by issuing stock to shareholder and the other one is the debt capital which can be termed as long term liability. These funds must be invested in a balanced way among non-current assets of the company that are expected to generate profits for the organization and the working capital requirements which is necessary for meeting short term and medium term cash requirements of the business. The best way to fund working capital is to fund the average annual requirement of working capital through long term finance and use short term finances to fund seasonal fluctuations.

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