Capitalization of profits: How Does It Work? Benefit and Limitation

Capitalization of profits refers to the conversion of the retained earnings of a company into capital which can then be issued to the shareholders of the company in the form of dividends or stocks.

Usually, the latter option of giving stocks is preferred to paying dividends. This option is mostly chosen by companies that do not want to use their cash reserves to pay dividends to the shareholders.

This is done in the form of bonus shares issue.

Capitalization

In financial terms, capitalization refers to the process of generating capital from something. In this case, capital is generated from the retained earnings of a business.

Therefore, capitalization of profits means converting the profits or retained earnings of the business into a capital stock that can be distributed to the company’s shareholders.

Retained Earnings

The retained earnings of a company represent its profits accumulated over time after distributing dividends to its shareholders.

Retained earnings are earnings kept by the company management to invest in the company’s activities or upcoming projects.

While shareholders prefer to be paid in dividends, retained earnings can also be beneficial for shareholders as they increase the market value of the shares of a company.

This can help shareholders generate income through capital gains.

Bonus Issue

Companies capitalize their profits by giving their shareholders bonus issue shares.

Bonus issue shares are shares paid to the shareholders of a company free of charge based on their current holding of shares.

Bonus issue shares do not require the company to pay the shareholders using their cash reserves.

See also  IS IT A GOOD IDEA TO GET A HOME EQUITY LOAN?

Bonus issues do not affect the net worth of a company, also known as its net assets, as it is done through the capitalization of profits.

For example, a company ABC Co. has the following equity reported in its Financial Statements:

Equity$
Share Capital (100,000 x $100)10,000,000
Retained Earnings2,000,000
Total Equity / Net Assets12,000,000

At the end of the year, the company announces bonus issues of 1 bonus share for every 20 shares.

This means that the company issued a total of 5,000 (100,000 x 1 / 20) new shares to its shareholders.

After the issue of shares, the Share Capital of the company will raise by $500,000 (5,000 x $100) while its Retained Earnings will decrease by the same amount.

After the adjustments, the equity of the company in its Financial Statements will be:

Equity$
Share Capital (100,000 x $100)10,500,000
Retained Earnings1,500,000
Total Equity / Net Assets12,000,000

While both the Share Capital and the Retained Earnings of the business have changed, the Total Equity of the business has remained same.

Thus, it can be deduced that the retained earnings of ABC Co. have been capitalized.

Benefits of Capitalization of Profits

There are many benefits of capitalization of profits, which are as follows:

Can help with cash flows

When profits are converted to equity instead of paying it as dividends, it can help with the cash flows of a company.

As there is no cash involved in the process, it means companies do not have to pay cash to generate capital. This can be beneficial for cash-starved companies.

See also  ACCOUNTING ENTRY FOR RIGHT SHARES ISSUE: ACCOUNTING ENTRY, DETAIL EXPLANATION

Signaling effect

When profits of a company are converted into capital, it can provide a signaling effect to the market about the company’s growth.

It signals to the market that the company has trust in its operations to provide long-term success for the company.

Furthermore, an increase in the capital of the company can lead to an increase in the perception of the company’s size.

Restructuring equity

Companies can use capitalization of profits to restructure their equity. If the retained earnings of the company exceed the share capital of that company, it can be an unfavorable position for a company.

Therefore, the company can restructure its equity by converting its retained earnings into capital.

Limitations of Capitalization of Profits

There are certain limitations of capitalization of profits, which are as follows:

May prove costly

For companies using bonus shares or capitalization of profits as an alternative to paying dividends, it may prove costly.

The company may avoid paying dividends for one year by issuing bonus shares but in the long term, the company will have to pay additional dividends on the shares issued using this method.

Affects some ratios

Capitalization of profits increases the issued share capital of a company. This may adversely affect some ratios of the company that depends on the issued share capital of a company.

For example, the Earnings Per Share ratio of the company will be adversely affected through an increase in the share capital of the company due to the capitalization of profits.

Conclusion

Capitalization of profits is the conversion of the retained earnings of a company into capital.

See also  How hard it is to get A Home Equity Loan? All You Need to Know

This can be achieved by issuing bonus shares to the shareholders of the company.

Capitalization of profits can have many advantages such as helping with cash flows of the company, acting as a growth signal to the market, or being used to restructure the equity of a company.

It may also have some drawbacks due to the long-term costs of capitalization of profits and affecting some ratios of the company adversely such as the Earnings Per Share ratio.

Scroll to Top