Undercapitalization

Undercapitalization Definition

Undercapitalization in term of business means a scenario where a business faces a shortage of fund or capital requirement to continue its day to day operations and this is prevalent or generally seen as a problem with small business firms. The business in these moments also faces the lack of ability to procure any new source of funding or capital.

Explanation

Undercapitalization can be a problem for any business, but it is generally prevalent and common for business units, which are on a small scale. It is considered a critical trigger for some serious financial problems within small business units. It can sometimes lead to closure or shutdown of the business, thus leading to grave business failure. The other problem is that it can restrict the firm from expansion or investing in other ventures because, with sufficient capital, every firm will find it extremely difficult to venture into new areas or expand.

UnderCapitalization

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How does it Work?

Undercapitalization takes place when companies are earning higher profits at a lower rate as compared to its peer operating in the same industry. It is a situation where the business has a lack of funds to support operations. It can also be a case where the value of assets a company holds is comparatively very high that what the company has raised in the form of capital. It is like suppose the average rate of return in the industry is 10%. Still, the company, whereas the company is making an earning at the rate of 20% on its capital employedCapital EmployedCapital employed indicates the company's investment in the business, i.e., the total amount of funds used for expansion or acquisition and the entire value of assets engaged in business operations. "Capital Employed = Total Assets - Current Liabilities" or "Capital Employed = Non-Current Assets + Working Capital."read more, which makes the company an undercapitalized business unit.

Example

Let us assume a company is running its full operations and earning a profit of $50,000 by employing a capital worth $10,000. Now the scenario is such the actual capital required to earn this amount of profit is $20,000, but the company is making money on the same capital but worth $10,000.  Thus the company is undercapitalized to a value of $10,000.

Causes

Below are some of the causes of undercapitalization.

  • The recessionary period where the assets get acquired/consumed: There can be scenarios where during periods of recession or unstable market conditions, the acquiring of the assets of the company happened at a low price, and when the conditions got better or reversed the same assets were generating higher levels of income with the usage.
  • The requirement of the company was not estimated properly: If a company does not possess the ability to assess the optimum requirement of its capital or there is the underestimation of the capital required, this also leads to undercapitalization because the company has lack of capital to support its day to day operations.
  • Plough back profits methodology: A company have the policy of ploughing back its profit and not issuing a dividend, which further leads to undercapitalization because of the incremental earning power of the firm/organization.
  • Management, which is efficient and conservative: Sometimes, management may decide to issue the bare minimum share capital and, on the other hand, adhere to the borrowing of funds at lower rates of interest from the market. It leads to the scenario of undercapitalization again.
  • Management policy to stock up reserves: At times, the management may decide to create reserves based on its capital for some hidden future plans, which again leads to the problem of undercapitalization.
  • Promotional strategy during the period of depression: A company during phases of depression may plan for promotional activities, but this again might lead to undercapitalization when there is an inflationary condition again, and the company experiences a sudden rise in earnings.
  • Improper estimation of future income: When the scenario is such that the company has underestimated its earning potential for the future and the actual money earner is quite higher than what it estimated, the company may also go to a phase of undercapitalization.

Effects of Undercapitalization on Investors and Company and Shareholders

Solutions

Drawbacks

  • Impact on Taxation: The company bears the burden of higher tax rate due to incremental earnings due to the rise of share value
  • Share Value Manipulation: Undercapitalization may force management to bring about unfair practices about the manipulation of share value
  • Effect on Consumer Sentiment: Customer feels cheated because of rising profits where they feel the company is overcharging them for the good or services.
  • Labour and Management Conflicts: The employees tend to demand more wages on finding the company is earning more profits.

Conclusion

Undercapitalization can be a problem for any business, but it is generally prevalent and common for business units which are in a small scale. It is considered a vital trigger for some serious financial problems within small business units and can sometimes lead to closure or shutdown of the business, thus leading to grave business failure. It can be solved by effective policies if implemented by the management.

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This article has been a guide to Undercapitalization and its definition. Here we discuss how it does work along with an example, causes, effects, solutions, and drawbacks. You can learn more about from the following articles –

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