Notes On Leverage Or Trading On Equity:

       The term leverage refers to the increased means of accomplishing some purpose. For example, leverage helps us in lifting a heavy object which may not be possible otherwise. However, in the area of finance, the term leverage has a special meaning. It is used to describe the firm�s ability to use fixed assets or funds to increase the return to the owners.

       James Horne has defined leverage as the employment of an asset or funds for which the company pays fixed cost or fixed return. Thus according to him, leverage results as a result of the firm's employment of assets or source of funds which has a fixed cost. The former may be termed as fixed operating cost while the latter may be termed as fixed financial cost.

Types of Leverage:

1. Operating Leverage:

       The operating leverage may be defined as the tendency of the operating profit to vary in opportunity with sales. A firm is said to have a high degree of operating leverage when it employs a greater amount of fixed cost and a small amount of variable cost and vice versa. Thus the degree of operating leverage depends upon the amount of fixed elements in the cost structure.

       Operating leverage in a firm is a function of three matters:

  1. The amount of fixed assets.
  2. The contribution of margin.
  3. The volume of sales.

2. Financial Leverage:

       Financial leverage is the ability of the firm to use fixed financial charges to magnify the effect of changes in EBIT on the firm's EPS

       Financial leverage may be favorable or unfavorable. The leverage will be considered favorable so long as the firm earns more than the assets purchased with the funds. Unfavorable leverage occurs when the firm does not earn much as the funds cost.

       Financial leverage greatly helps the financial manager in devising the capital structure of the company. A high financial leverage means a high fixed financial cost and high fixed financial risks. The finance manager must plan the capital structure of the company in such a way that the firm is in a position to meet its fixed financial cost.

3. Composite Leverage:

       Operating leverage measures the percentage change in the operating profit due to the percentage change in sales. Financial leverage measures the percentage change in taxable profits on account of percentage change in operating profits. Thus it explains the degree of financial risk. Both these are concerned with the firm's ability to meet its fixed cost both operating and financial. Composite leverage expresses the relation between revenue on account of sales and the taxable income. It helps in finding out the resulting percentage change in taxable income on account of percentage change in sales.

Meaning Of Over Capitalization, Its Causes And Effects And Remedial Measures

       The phrase "Over Capitalisation" has been misinterpreted as abundance of capital. But in actual practice, the overcapitalization concern has been found short of funds.

       Precisely, a company is said to be overcapitalization when its earnings are consistently insufficient to provide a fair rate of return on the amount of capital investment.

       The following are some of the definitions of capitalisation:

Defined by Grestenberg:

       In the opinion of Grestenberg, "A corporation is over capitalized when its earnings are not enough to yield a fair return on the amount of stocks and bonds that have been issued or when the amount of securities outstanding exceeds the current value of the assets."

Defined by Bonneville, Dewey and Kelly:

       In the words of Bonneville, Dewey and Kelly, "When a business is unable to earn a fair rate of return on its outstanding securities, it is overcapitalization"


  1. Lower rate of earnings and prevailing in similar companies in the same industry over a fairly long period of time.
  2. Lower rate of dividends over a long period of time.
  3. Lower market rate of shares then the book value of the shares over a long period of time.

       The comparison of the book value with the real value of shares is the most satisfactory standard to test the state of over-capitalisation.

Causes of Over-capitalisation:

1. High Promotional Expenses:

       A company is said to be over capitalized when it spends huge amount of money to promote their services, or value their goodwill at the rate higher than what it is. Similarly, when the assets of partnership firm or a private limited company are transferred at an inflated price in case of conversion of the firm into a company, the company will become over capitalization because the book value of the company's assets will be higher than its real value.

2. Acquiring of Assets during Inflationary Period:

       If a Company purchases fixed assets during inflationary period, the mount of capitalisation of the company would be high this is because of the reason that after the boom period or during the period of recession, the real value of the assets of the company would fall while the book value of the assets would remain at the higher level. Thus the company becomes over capitalization

3. Raising Excessive Capital:

       A company can also become over capitalized if it raises excessive capital than it can effectively utilized. The company's market value will fall as large amount of capital would remain unutilized that will have an tolling effect on the company as these unutilized capital has a cost of raising and also has to borne interest.

4. Depreciation Policy:

       Inadequate provision for depreciation and replacement will enable the company to yield higher returns but not for long period. As the working capacity of the fixed assets of the company falls, the earnings of the company will also fall and the share price of the company will start to decline indicating over capitalisation. This is because with no or inadequate provision for depreciation, the book value of the assets of the company remains the same while the real value of the machine decreased due to its usage.

5. Shortage of Capital:

       Shortage of capital due to faulty financial planning compels the company to borrow capital at higher rate of interest. A large portion of the profits of the company is given away to the creditors as interest leaving very little to be distributed as interest to the shareholders. As the rate of dividend falls, the market value of the share also falls which shows over capitalisation.

6. Taxation Policy:

       The rigorous taxation policy of the government also results in over capitalisation. Due to higher tax burden on the company, a good amount of profit gets exhausted in payment of taxes and the remaining balance becomes very less for the distribution of dividends to the shareholders which again becomes a symptoms of over capitalisation. The company may have to face shortage of funds for financing repairs and renewals or to meet its working capital requirement.

Effects of Over Capitalisation:

I Effects Of Leverage On The Company:

  1. It reduces the earning capacity of the company decreases the confidence of the shareholders of the company which in turn reduces the goodwill of the company.
  2. It faces difficulty in acquiring capital due to low rate of interest prevailing in the market.
  3. An over company has low credit standing and goodwill and as such the financial institutions hesitate to grant loan.
  4. An over company has high risk of liquidation as it may not be able to pay the principle amount of loan and the interest thereon to the creditors.
  5. An overcompany cannot compete in the market because of its inability to produce goods at competitive costs.

II Effects Of Leverage On The Shareholders:

  1. The shareholders get low dividend on their investments
  2. The shareholders also suffer a capital loss as because the market value of their shares falls and they have to sell their shares below par.
  3. The value of the shares as collateral securities is very less. The financial institutions do not sanction loan against such shares.
  4. The low priced shares of overcapitalization company encourage speculative gambling.

III Effects Of Leverage On The Society:

  1. An over concern, to increase its profit; reduces the quality of its products and increases its price. Thus, it affects the consumers directly.
  2. To increase its profit, an overcapitalization company reduces the wages and salary of its workers. This lowers their standard of living.
  3. Over-are concern are often forced to close down creating wide spread unemployment.
  4. The industrial and economic development of the country is adversely affected because the investor does not invest funds in over capitalized concern.
Remedies of Over Capitalisation:

1. Reduction in Funded Debts:

       To control the situation of over-capitalisation, the company should reduce the amount of funded debt through outright reorganization. The Debentures and bonds should be immediately redeemed out of the accumulated earnings of new issue.

2. Reduction in Interest Rates of the Debentures:

       An over capitalized company should try to reduce its interest rates on debentures. It should try to convince the existing debenture holders to accept new debentures at lower rate of interest.

3. Redemption of Preference Shares:

       The amount of over-capitalisation may be reduced by reducing the preference shares carrying high rate of dividend.

4. Reduction of the par value of the shares:

       A company may also reduce the number of shares to control the situation of over-capitalisation through consolidation of shares. The shareholders may be given one share in exchange of several shares. The earnings per share will go up without affecting the amount of capitalisation. This will help the company in raising funds for future development.

5. Ploughing Back of Profits:

       In the initial stage of capitalisation, the company may restore to ploughing back of profits by suspending the distributions of dividends for few years. This will increase the amount of its real value without an extra burden on its resources.

       In short, re-organisation of share capital either by reducing its par value or by reducing the number of outstanding shares is the only panacea to the problem of over-capitalisation