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.
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FAQs
What Actions Must Companies Take if Their Capital is Impaired?
If a company’s capital is impaired, it may be legally required to suspend dividend payments to preserve remaining equity. The company might also need to notify regulators or shareholders, depending on jurisdictional requirements. In severe cases, it may be compelled to restructure, recapitalize, or even dissolve to protect creditors’ interests.
What is the 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.