Undercapitalization: Definition, Causes, and Examples

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.

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. Investors want to proceed with caution if a company is undercapitalized because the chance of bankruptcy increases when a company loses the ability to service its debts.

How Undercapitalization Works

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. Being undercapitalized can lead to a significant drag on growth, as the company may not have the resources required for expansion, leading to the eventual failure of the company. Undercapitalization can also occur in large companies that take on significant amounts of debt and suffer from poor operating conditions.

Key Takeaways

  • Undercapitalized companies do not have enough capital to pay creditors and often need to borrow more money.
  • Young companies that do not fully understand initial costs are sometimes undercapitalized.
  • When starting, entrepreneurs must asset their financial needs and expenses—then err on the high side.
  • If a company can't generate capital over time, chances of going bankrupt increase, as it loses the ability to service its debts.

If undercapitalization is caught early enough, and if a company has sufficient cash flows, it can replenish its coffers by selling shares, 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 can have a number of causes, such as:

  • Poor macroeconomic conditions that can lead to difficulty in raising funds at critical times
  • Failure to obtain 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

Examples of Undercapitalization in Small Business

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 or wages, equipment and fixtures, licenses, inventory, advertising, and insurance, among others. Since startup costs can be a significant hurdle, undercapitalization is a common issue for young companies.

Because of this, 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.

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