Capitalisation

Capitalisation

Capitalisation is a popular and efficient way for companies to raise money. It can also help to diversify funding sources and provide the funds needed for growth. However, it can also be expensive and dilutive to a company’s ownership structure. 

Here, we provide a more elaborate overview of capitalisation. 

What is capitalisation?

Capitalisation in accounting refers to recording an asset’s cost as part of the company’s balance sheet. This cost is then depreciated over the asset’s useful life.  

In finance, capitalisation refers to the process of raising funds by issuing shares of stock or taking out loans. The funds can then be used to finance the company’s operations or expand its business.

Understanding capitalisation

Capitalisation refers to raising funds for a business venture by selling equity or debt instruments. The most common types of capitalisation are equity financing, debt financing, and hybrid financing. Equity financing involves the sale of ownership interests in a business to investors. Debt financing consists of the borrowing of funds from lenders. Hybrid financing is a combination of equity and debt financing. 

Capitalisation is a key component of the business cycle, as it is the source of funding for businesses to expand and grow. Without capital, companies would be limited in their ability to invest in new products, processes, or services and could not finance expansion costs. Capitalisation is also a key factor in determining a company’s valuation.

Types of capitalisation

Generally, there are three types of capitalisation. 

• Normal capitalisation 

Normal capitalisation is something we already recognize. It is nothing more than a valuation or estimate of the current value being used.  

• Under capitalisation 

A company that generates disproportionately high earnings for its industry is undercapitalized. When the expected revenues are far below the actual profits, an undercapitalized company problem develops. 

As a result there are more profits, more generated funds, a high degree of income, and goodwill. The business also sees a rising trend in the ROI as a result.  

A variety of factors can cause undercapitalisation like: 

• Buying of assets at discounted prices 
• Low costs for promotion 
• Prudent dividend policy 

• Highly effective directors 
• A company flotation during a recession 
• Preserving substantial secret reserves 
• Adequate depreciation provisions 
• Over-capitalisation 

Many people mistakenly associate “under-capitalisation” with a lack of capital and “over-capitalisation” with an overflow of capital. So, it is vital to go into depth about these concepts. When an organization’s earning potential does not support the level of capitalisation, it is said to be overcapitalized. 

Some of the leading causes of over-capitalisation are: 

• The steep cost of promotion 
• Inadequate funding for depreciation purposes 

• Flotation of the business during the boom time 
• A policy of liberal dividends 
• Overestimation of overall income 

When is capitalisation used?

Capitalisation is a fundamental accounting rule that allows a cash transaction to be recorded on the balance sheet as an asset as opposed to an expenditure on the income statement. In general, capitalisation costs are advantageous since companies may amortize or depreciate them when they incur spending on new assets with extended lifespans. 

Capitalisation in finance is a numerical evaluation of a company’s capital structure. 

Effects of capitalisation

We know capitalisation refers to the process of raising funds through the sale of shares or bonds. The effects of capitalisation on financial statements are twofold.  

• First, it allows a company to obtain the funds necessary to finance its operations and expand its business. Second, it can increase the value of the company’s shares, which can benefit shareholders. 
• Additionally, capitalisation of expenses results in better net income, lower leverage ratios, and reduced net income fluctuation compared to expensing expenses. 
• Capitalisation of interest results in reduced interest expenditure, considerably higher depreciation, better operating cash flow, and a higher interest coverage ratio. Analysts frequently change financial statements to eliminate the consequences of capitalized interest. 
• Unless capitalized expenditures are rising, capitalisation drives return on equity (ROE) and return on assets (ROA) to be more significant in the year of capitalisation and lower in the following years. 

• Costs associated with intangible assets are typically capitalized when they are purchased from an external source. Only legal expenditures paid internally to secure a patent are eligible for capitalisation under US CAAP. And if technical and financial viability has been proved, costs associated with developing software destined for external sale are also eligible. 

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