What is 'Undercapitalization'

Undercapitalization occurs 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 initial costs associated with getting a business up and running. It can lead to a significant drag on growth, as an undercapitalized company may not have the resources required for expansion. It can even lead to the failure or a company. 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 a company has sufficient cash flows, it can replenish its coffers by selling shares or issuing debt, or obtaining a long-term revolving credit arrangement with a lender. However, if a company is unable to produce net positive cash flow or access any forms of financing, it is likely to go bankrupt.

Undercapitalization Causes

Undercapitalization can have a number of causes, such as:

  • Poor macroeconomic conditions which can lead to difficulty in raising funds at critical times
  • Failure to line up a line of credit
  • Funding growth with short-term capital rather than permanent capital
  • Poor risk management, such as being uninsured or underinsured against predictable business risks

Undercapitalization and Small Businesses

When starting a business, entrepreneurs should conduct an assessment of their financial needs and expenses — and err on the high side. Common expenses for a new business include rent and utilities, salaries/wages, equipment and fixtures, licenses, inventory, advertising, and insurance, among others. As such, small business startups should create a monthly cash flow projection for their first year of operation at least and balance it with projected costs. Between the equity the entrepreneur contributes and the money they are able to raise from outside investors, the business should be able to be sufficiently capitalized. In some cases, an undercapitalized corporation can leave an entrepreneur liable for business-related matters. This is more likely when corporate and personal assets are commingled, when the corporation's owners defraud creditors, and when adequate records are not kept.

RELATED TERMS
  1. Corporate Finance

    Corporate finance is the division of a company that deals with ...
  2. Entrepreneur

    An entrepreneur is an individual who founds and runs a small ...
  3. Corporate Debt Restructuring

    Corporate debt restructuring is the reorganization of a distressed ...
  4. Capital Funding

    Capital funding is the money that lenders and equity holders ...
  5. Cash Flow

    Cash flow is the net amount of cash and cash-equivalents being ...
  6. Operating Cash Flow (OCF)

    Operating Cash Flow (or OCF) is a measure of the amount of cash ...
Related Articles
  1. Small Business

    Why Equity Financing Is Worth It

    When a business takes on an equity partner, it is exposed to a number of advantages that debt financing simply cannot provide.
  2. Small Business

    In Entrepreneurship, Failure Doesn't Have to Be Fatal

    There is an inherent risk to starting any type of business, but being an entrepreneur with a plan can help you succeed or try again if necessary.
  3. Trading

    Are You Ready To Be A Professional Trader?

    Here's help in making the quantum leap from novice to crackerjack trader.
  4. Investing

    Why Cash Management Is Key To Business Success

    Businesses need to generate a healthy cash flow to survive, but not hold too much so that inventory suffers or investment opportunities are missed.
  5. Small Business

    Explaining Cost Of Capital

    Cost of capital is the cost of funds used to finance a business.
  6. Small Business

    The 4 Most Common Reasons a Small Business Fails

    Discover the most common reasons small businesses fail, including capital formation, management concerns, planning issues and marketing missteps.
  7. Investing

    What Is Cash Flow From Investing Activities?

    Cash flow from investing is listed on a company's cash flow statement and includes any inflows or outflows of cash from a company's long-term investments. 
  8. Small Business

    How Financial Planning Differs for Entrepreneurs

    There are a number of ways in which financial planning differs for entrepreneurs.
  9. Investing

    Evaluating A Statement Of Cash Flows

    The metrics for the Statement of Cash Flows is best viewed over time.
RELATED FAQS
  1. How can I calculate the leverage ratio using tier 1 capital?

    Learn about the tier 1 leverage ratio, how to calculate the tier 1 capital ratio and what this leverage ratio indicates about ... Read Answer >>
  2. How can I calculate the tier 1 capital ratio?

    Learn about the tier 1 capital ratio, what the ratio indicates about a firm's capital adequacy and how to calculate a firm's ... Read Answer >>
  3. What changes in working capital impact cash flow?

    Working capital is the amount of money a company has available to pay its short-term expenses. Cash flow is the amount of ... Read Answer >>
  4. Why would a company use a form of long-term debt to capitalize operations versus ...

    Learn about the different consequences of using long-term debt versus equity to raise capital for business activity, and ... Read Answer >>
  5. How do interest rates influence a corporation's capital structure?

    Learn about how changing interest rates can affect a corporation's capital structure because of their impact on the cost ... Read Answer >>
Trading Center