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Both of these are definitely bad for a firm.
Undercapitalization is when the capital owned by the firm is too much less than the capital borrowed by the firm. In such a situation, the firm will likely be
- Paying excessively high interest charges
- Losing productivity by producing on obsolete machinery
Overcapitalization is the opposite problem. In this case,
- Dividend and interest payments will likely be too high relative to earnings.
This is because the capital is not being used efficiently.
Remedies could include splitting shares to correct undercapitalization and buying back shares to correct overcapitalization.
Overcapitalization is dangerous for firm due
- IT result in unnecessary accumulation of inventories , which lead to mishandling of inventories, waste , thefts and losses in increase
- It is indication of defective credit policy and slack in collection period these lead to higher bad debt losses that reduce profit.
- It makes management complzcement which degenerate in to managerial inefficiency.
- Accumulations inventories tend to make speculate profit grow. This type of speculation makes the firm o follow liberal dividend policy and difficult to cope with in future is unable to make speculative profits.
Undercapitalizations are dangerous to the firm due to
- It stagnates growth. It become difficult for the firm to undertake profitable or the firm to undertake profitable of the firm to understand profitable projects for non availability of working capital
- It become difficult to implement operating plans and achieve the firm’s target profit
- Operating inefficiencies creep in when it become difficult even to meet day to day commitments
- It leads to inefficient utilization of fixed assets. Thus, firms profitability would deteriorate
- It render the firm to avail attractive credit opportunities etc.
- Firm loses its reputation when it is not in a position to honor its short –term obligations. Therefore, firm should maintain the right amount of working capital on a continuous basis
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