Impaired Capital: What It Is and What to Do About It

Impaired capital describes a financial situation where a company’s total capital is less than the par value of its capital stock. This occurs when a company’s assets are no longer sufficient to cover its liabilities plus the minimum legal capital it must maintain, known as stated capital. When this capital cushion is eroded by losses, the company’s financial foundation is considered impaired, signaling potential distress to investors and creditors.

Identifying Impaired Capital

Identifying impaired capital involves comparing a company’s assets to its liabilities and stated capital. Stated capital represents the nominal or par value of all issued shares of stock. This figure is a fixed value assigned for legal purposes and is not the stock’s market price.

The formula to determine if capital is impaired is: Total Assets < (Total Liabilities + Stated Capital). For example, a company with total assets of $500,000, total liabilities of $350,000, and stated capital of $200,000 has impaired capital. The calculation shows its assets ($500,000) are less than its liabilities and stated capital combined ($550,000), resulting in a $50,000 impairment. These figures are found on the company's balance sheet in the assets, liabilities, and shareholders' equity sections.

Common Causes of Capital Impairment

Capital impairment is a symptom of significant financial distress. One of the most frequent causes is sustained operational losses. When a company consistently spends more than it earns, it accumulates a deficit in retained earnings, which reduces the equity on the balance sheet and can lead to impairment.

Another cause involves significant write-downs in the value of assets, such as real estate, equipment, or goodwill. Such a write-down is recorded as a loss, which reduces net income and, consequently, shareholders’ equity. The distribution of excessive dividends can also lead to impaired capital if a company pays out more in dividends than it generates in profit over time.

Consequences of Impaired Capital

A company with impaired capital faces serious legal and business repercussions. The most immediate consequence is a legal restriction on paying dividends to shareholders. Corporate laws are designed to protect creditors by ensuring a minimum level of capital is maintained within the company; paying dividends when capital is impaired violates this principle.

Capital impairment also damages a company’s reputation and its ability to secure financing, making lenders and investors hesitant to extend credit or invest further. Existing loan agreements may contain covenants that are triggered by capital impairment, potentially allowing lenders to demand immediate repayment of outstanding loans.

For regulated industries like banking and insurance, the consequences are more severe. Regulatory bodies require these institutions to maintain specific capital adequacy ratios. Falling below these thresholds can trigger swift regulatory intervention, including mandated corrective actions or forced liquidation.

Addressing Capital Impairment

Once capital impairment is identified, a company can take several steps to restore its financial health. One direct approach is to secure a new infusion of capital by issuing new shares of stock to investors, which increases the company’s assets and equity.

Another strategy involves corporate restructuring. A company might negotiate with creditors to convert outstanding debt into equity, which reduces total liabilities while increasing shareholders’ equity. In some cases, a company may legally reduce the stated par value of its stock, which lowers the threshold for impairment, though this often requires shareholder approval.

The most sustainable solution is to address the underlying operational issues that caused the losses. Returning to profitability will increase retained earnings over time, naturally curing the capital impairment.