Difference Between Overtrading and Overcapitalization (With Table)

Running a business in today’s competitive world is not an easy task. It requires consistent and diligent efforts. The company might do more trading than they have anticipated. Sometimes they might invest in more debt. There are two methods to overcome this. Overtrading and Overcapitalization will be a good solution for their problem. 

Overtrading vs Overcapitalization

The difference between Overtrading and Overcapitalization is that in overtrading, the broker or invest traders will do more trading. But in overcapitalization, the company will invest in more debts and equity. It is used by many companies, but it will be preferred depending upon the risk factors. Overtrading is a term used in accounting. Overcapitalization is used in describing capital. 

In order to avoid this risk of overtrading, the broker or individual traders should have some self-control practices such as self-awareness and risk management. There may be many reasons for overtrading, and the result will be sometimes good and poor. It depends on the type of work we do and where we invest that money for trading purposes.

Overcapitalization primarily occurs due to investments in debt and equity. In order to escape from Overcapitalization, there is one method for it. The first thing the company is expected to do is reducing the debt load. They can even buy the shares of the dividend payments as well. Even Restructuring the company will also become a solution to this problem. 

Comparison Table Between Overtrading and Overcapitalization

Parameters of ComparisonOvertradingOvercapitalization
DefinitionIt is the process of buying or selling stocks excessively.It is the process of investing in debts.
AdvantagesIt reduces the risk of inventory levels.The company will have excess cash in its sheet balance.
DisadvantagesIt will result in loss because of trading without taking care of risks.When we do reorganization, many problems will be created.
Working CapitalIt will be less in overtrading.It will be high in overcapitalization.
FundsFunds will be restricted.Funds will be managed in a poor way.

What is Overtrading?

Overtrading is defined as buying or selling excessive stocks. This can be done by brokers as well as individual traders. Both have different kinds of impacts, situations, and implications. They can frame the number of risks to be taken. Because if they take too much risk, it will lead to the destruction of the company. They have all rights to take risks when it comes to business. They even consider the number of trades that are appropriate.

If they reach a certain limit, then continuing it will become difficult. It will be bad either for the trader or broker, but it did not matter to the outsiders. This happens when they do overtrade by buying excessive shares and shocks without seeing any improvement. This will definitely lead to a problem. It will be observed by the investors when they find a surge in their development and profit. Also, the commission amount will be high when they do overtrade without any development in the business.

There are three types of overtrading as Discretionary Overtrader, Technical Overtrader, and Shotgun Overtrader. There are few steps by which we can prevent overtrading as exercising self-awareness, taking a break from work, Creating rules before doing something, and should be committed to the risk managing factors. 

What is Overcapitalization?

Overcapitalization will occur when the company invests in more debt and equity without considering the assets of the company. This, in turn, will reduce the market value of the company than what is has anticipated in the total value of the company. If a company is overcapitalized, then it will pay more interest and as well dividend payments. This will continue for a long period of time. 

It depends upon the company and how faster they are taking care of the situation. The interest and the dividend payments may or may not sustain for a long period of time, depending upon the amount of money they have capitalized. If they do overcapitalization beyond their limits and capacity, then it will eventually lead to bankruptcy of the company. The company will face huge losses because of this, and it will be difficult for them to pay their employees. This, in turn, will result in unemployment. 

The opposite of overcapitalization is undercapitalization. This term overcapitalization is mostly used in industrial markets and their areas. This will affect the low premium insurance policies. But it has one good advantage, and that is why some companies are still practicing that. It helps to maintain the excess cash in the form of a balance sheet. This cash will help us to return the nominal rate, which in turn will increase the company’s liquidity. 

Main Differences Between Overtrading and Overcapitalization

  1. In overtrading, the company’s management can be increased without investing more capital. On the other hand, in overcapitalization, the market value of that company will be less when compared to the capitalization of that particular company.
  2. In overtrading, more working capital will be less needed. On the other hand, in overcapitalization, working capital will be more needed.
  3. In overtrading, the effective rate may either remain or increase. In overcapitalization, it will be less when compared with other capitalization.
  4. Overtrading can be reduced by practicing some self-awareness techniques. But overcapitalization will be reduced only when the company meets the selected criteria.
  5. In the future, the company cannot invest because of the losses they faced earlier. But in overcapitalization, the company will be in an invested state for the future.

Conclusion

Both Overtrading and Overcapitalization are used by the company. These two methods will work efficiently, but it depends upon the project they do. It depends on their investment. There are ways to come out from overtrading and overcapitalization problems. Since it will be difficult to predict the profit, there will be options to come out from the discrepancies.

Overtrading will impact the entity in the cash flow method as well. Overcapitalization has to bear this kind of entity. These things will come under the accounting stream. It will be taught well in their higher studies, and they will implement them in the workplace. 

References

  1. https://www.taylorfrancis.com/chapters/edit/10.4324/9780203816547-25/heinrich-herkner-inequality-income-distribution-overcapitalization-underconsumption-harald-hagemann
  2. https://air.ashesi.edu.gh/handle/20.500.11988/137
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