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 company’s shareholders in the form of dividends or stocks.

Usually, the latter option of giving stocks is preferred to paying dividends. This option is mainly 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 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

A company’s retained earnings represent its profits accumulated over time after distributing dividends to its shareholders.

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

While shareholders prefer to be paid in dividends, retained earnings can also benefit 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 on 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.

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.

See also  How Does Reduction Of Working Capital Help The Company Improve Their Cash Flows?

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 rise 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 the 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 a company’s cash flows.

No cash is involved in the process, so companies do not have to pay cash to generate capital. This can be beneficial for cash-starved companies.

Signaling effect

When the 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.

See also  Asset Management Firm Vs. Private Equity Firm: What is the Difference?

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

Restructuring equity

Companies can use capitalization of profits to restructure their equity. If the company’s retained earnings exceed its share capital, 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 to the 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 by an increase in the company’s share capital due to the capitalization of profits.

Conclusion

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

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

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

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

See also  5 Reasons Why Getting a Home Equity Loan is Not a Good Option