# If assets = liabilities + equity, what do we mean by overcapitalization?

Overcapitalization doesn't seem to have a clear-cut definition.

For some it seems to deal with the ratio of current output (Y) over optimal output (Y*). A company would then be overcapitalized if Y < Y*, meaning it could raise its output without having to recapitalize.

Others define it as Equity + Debt > "True Value of assets"

I like the second definition but it is subjective.

I am trying to understand the concept of overcapitalization in the context of a firm's valuation.

• It usually means that the amount of capital available to a firm is in excess of what is required by the projects that are available for the firm to undertake (and are expected to provide a sufficient risk-adjusted return). The result of this is that the firm will provide a poor return to its investors. If the firm can't find better opportunities, its best option is to reduce the amount of capital available to it by retiring debt or engaging in stock buy-backs. – dismalscience Apr 18 '15 at 14:23
• So could it be approximated by a ratio like Working Capital / Liabilities ? I'm trying to measure it as well as define it. – user1627466 Apr 18 '15 at 14:26
• Should you change your title to "assets = liabilities + equity?" Did you mean to write "assets = liabilities?" – jmbejara Apr 21 '15 at 1:36

A firm's Output $Y$ (in value-added terms, i.e. over and above the value of purchases of third-party services and materials) is distributed as reward to the factors of production. Denote $K$ the book value of the company's assets. Use the standard notation $L$ for payments to the labor/human capital input to production. Denote $r$ the capital rate of return as measured with respect to the book value of firm's capital and denote $w$ the average remuneration of human capital services. Then we have

$$Y = rK + wL$$

Depending on the market, the industry, and a few other things, we can estimate $r^*$, the rate of return that the firm "should" have on average, if it should be judged as an efficient user of capital allocated to it, for given output and human capital costs. $r^*$ is usually estimated by what are the returns on the market and the industry (we do not go outside the industry since we recognize the existence of "asset specificity"). Associated with $r^*$ goes the efficient level of capital, $K^*$. So we also have

$$Y = r^*K^* + wL$$

$$rK = r^*K^* \implies r = r^*\frac {K^*}{K}$$

If we have that

$$r < r^* \implies r^*\frac {K^*}{K} < r^* \implies K^* < K$$

and we can say with some certainty that the inequality does not show a tendency to change in the near future, then we can argue that the company does not make efficient use of the current amount of capital it appears to have, either due to "functional inefficiency" (how things are organized and work inside the company and in the delivery of of its business, a qualitative aspect), or due to plain under-utilization of the existing capital (a quantitative aspect).

The "over-capitalization" story essentially assumes "functional efficiency" but it sees under-utilization of capital, and so it advocates the reduction of the capital/assets currently under the control of the company.

To measure it we have the relation ($K_E=$ Excess Capital)

$$K_E = K - K^* = K- \frac {r}{r^*}K = \left (1-\frac {r}{r^*}\right)K$$

$r$ and $K$ is measured from the firms financial statement, while $r^*$ from Industry weighted averages.

• Thanks but I'm concerned about estimating r* as in some instances the whole industry is over capitalized (Oil in the 1980s). – user1627466 Apr 19 '15 at 6:48
• In Industries were "overcapitalization" can be approached in an "engineering way", i.e. where we can obtain a measure of "installed output capacity" and compare it to actual production, we can have a direct measure of the amount of capital that it "rests idle". – Alecos Papadopoulos Apr 19 '15 at 11:51

I don't think the term is very well defined. I think it depends on the context. I have maybe two possibilities. I'll try to provide references with each.

# Possible Definition 1

The first coincides with @Alecos' answer. The following is taken from the beginning of "The Over-Capitalization Effect with Diversification and Cross Subsidization," by Rozek, published in the journal Economic Letters:

A basic component of the theory of regulation is the model developed by Averch and Johnson (1962). The main result is that a monopolist, subject to a rate of return constraint, will select a larger capital-labor ratio than the one that minimizes costs for the output level it decides to produce. This result is known as the over-capitalization or A-J effect. A crucial assumption in this model is that the allowed rate of return is greater than the market cost of capital. If the reverse is true, the regulated monopolist will actually under-capitalize.

# Possible Definition 2

The second possible definition coincides with the definition given on Investopedia.com.

When a company has issued more debt and equity than its assets are worth. An overcapitalized company might be paying more than it needs to in interest and dividends. Reducing debt, buying back shares and restructuring the company are possible solutions to this problem. ... The opposite of overcapitalization is undercapitalization, which occurs when a company has neither the cash flow nor the access to credit that it needs to finance its operations. Undercapitalization most commonly occurs in companies with high start-up costs, too much debt and/or insufficient cash flow and can ultimately lead to bankruptcy.

Whereas the first definition was one that dealt with efficient use of inputs of production this second definition deals more with capital structure in the corporate finance literature.

This reminds me of the "free cash flow problem." This is an agency problem described in the corporate finance literature that arises in cash-rich firms. I'm assuming that over-capitalization can refer to this situation. That is, they have more cash than is needed to finance their operations. Here is a basic description of the free cash flow problem, given in Jean Tirole's book The Theory of Corporate Finance:

Following Easterbrook (1984) and Jensen (1986, 1989), Section 5.6 focuses on cash-rich firms, defined as firms with cash inflows exceeding their efficient reinvestment needs or opportunities. Such firms have excess liquidity that must be “pumped out” in order not to be used on wasteful projects, unwarranted diversifications, perks, and so forth. Jensen’s (1989) list of industries with potential free cash- flow problems includes steel, chemical, television and radio broadcasting, brewing, tobacco, and wood and paper products. Overall, the liquidity-shortage and free-cash-flow problems are two sides of the same coin. The key issue in the design of long-term financing is to ensure that, at intermediate stages, the right amount of money is available for the payment of operating expenses and for reinvestment and the right amount is paid out to investors. Whether this results in a net inflow (the liquidity-shortage case) or outflow (the free-cash-flow case) is important for the comprehension of corporate financing, but is a pure convention as far as economic principles are concerned. And, indeed, we merely reinterpret the liquidity-shortage model in order to obtain its flip side, the free-cashflow model.

• "Section 5.6 focuses on cash-rich firms, defined as firms with cash inflows exceeding their efficient reinvestment needs or opportunities." I think it is still the same problem as r*. We agree on its existence but we don't really know how to measure it. This does not seem to be a problem for economists but there isn't a accounting.stackexchange.com – user1627466 Apr 20 '15 at 11:52
• @user1627466. Are you saying that you believe that the definitions that I listed refer to the same thing? They are not the same. Also, which problem are you referring to when you say that "this does not seem to be a problem for economists?" – jmbejara Apr 20 '15 at 17:01
• No I just meant that defining cash-rich firms as cash inflows > efficient reinvestment needs means that you've established this need. Just like Alecos' explanation with r*. Economists like to deal with concepts like capital but are not very interested in their accounting materialization, and I'm saying this as an economics student. – user1627466 Apr 20 '15 at 17:38