Impaired capital definition

What is Impaired Capital?

A company has impaired capital when the aggregate amount of its capital is less than the par value of its shares outstanding. This situation arises when a firm has lost capital, either by issuing an excessive amount of dividends, by incurring losses (known as a retained deficit), or a combination of the two. If the company later earns a profit or gains equity from a stock offering, it can reverse the situation.

Depending on the laws of the state in which a business incorporates, it may not be possible to pay dividends that would create a retained earnings deficit. If so, the only cause of an impaired capital situation is the incurrence of losses.

Example of Impaired Capital

Gatekeeper Corporation runs a toll road. In a typical year, it spends 50% of its receipts to operate and maintain the toll road, 40% to pay off the bond used to finance the original road construction, and 10% to pay a dividend to investors. At the end of its last reporting year, it had $100,000 of equity par value on its balance sheet, as well as $500,000 of retained earnings. In the current year, Gatekeeper experiences a sharp drop in receipts as drivers elect to work from home for several days each week, resulting in a full-year loss of $600,000. In addition, its investors insist on being paid a $50,000 dividend. The result is an impaired capital situation, where the firm has a negative equity balance.

Impact of Impaired Capital

The existence of impaired capital is a strong indicator that a business is experiencing financial distress. This can trigger clauses in the firm’s lending documents that allow lenders to call their loans at once, which may result in the organization’s bankruptcy.

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