What Is Capitalization Of Profits?

Capitalization of profits is the use of a corporation's retained earnings (RE) to pay a bonus to shareholders in the form of dividends or additional shares. It is a reward to shareholders, distributed in proportion to the number of shares each owns.

Key Takeaways

  • Capitalization of profits is the use of corporate reserves to pay a bonus to shareholders in the form of cash or additional shares.
  • Rewarding shareholders is one of the primary uses of corporate cash reserves.
  • The process has no impact on a corporation's book value.

Understanding Capitalization Of Profits

Capital means assets of value. So, capitalization of profits implies that a company is transforming its cash reserves into assets of value, and transferring those assets to shareholders.

A company's cash reserves are its profits. This is the money it has received as payment for its products or services, above and beyond what it has spent to deliver them. There are a few ways that a company can use its profits. It can plow the money back into the business, using it to improve or expand its product lines, or it can keep it on the balance sheet for some future, yet-unidentified opportunity.

Alternatively, the company can return some or all of that profit to its shareholders, in the form of cash dividends or new shares. The capitalization of profits by issuing additional shares has no impact on a corporation's book value. It merely transfers funds from RE, or profits, to assets for shareholders. In that sense, the company is using money but not losing it.

There is always pressure on a company to use its profits, and using them to reward shareholders is always a popular option.

A corporation may be limited by its own articles from issuing bonus shares above a certain amount. In such cases, the corporate officers simply change the articles to raise the limit.

Other Uses of Capitalization

The word capitalization has a bewildering number of uses in the financial world. In general, it means turning something into money or providing money. For instance, investors provide a company with capitalization by buying shares of its stock.

A few of the more common usages of the term capitalization include:

  • Market capitalization, or market cap, is a measure of the actual value of a company. It is calculated by multiplying the current share price by the number of shares outstanding.
  • Large capitalization, medium capitalization, or small capitalization, more commonly called large cap, medium cap, and small cap, is a way to lump companies into categories based on their size or market cap.
  • Thin capitalization means that a company has an excessive amount of debt in comparison to its overall shareholder equity (SE).