DEFINITION of 'Undercapitalization'

When a company does not have sufficient capital to conduct normal business operations and pay creditors. This can occur when the company is not generating enough cash flow or is unable to access forms of financing such as debt or equity. If a company can't generate capital over time, it increases its chance of going bankrupt as it loses the ability to service its debts. Undercapitalized companies also tend to choose high-cost sources of capital, such as short-term credit, over lower-cost forms such as equity or long-term debt.

BREAKING DOWN 'Undercapitalization'

Being undercapitalized is a trait most often found in young companies that do not adequately anticipate the start-up costs associated with getting a business up and running. It can also occur in large companies that take on significant amounts of debt and suffer from poor operating conditions.

If undercapitalization is caught early enough, and if the company has sufficient cash flows, it can replenish it coffers by issuing stock or debt, or obtaining a long-term revolving credit arrangement with a lending group. However, if a company is unable to produce net positive cash flow or access any forms of financing, it is likely to go bankrupt.