Undercapitalization

Updated on May 15, 2024
Article byWallstreetmojo Team
Edited byAaron Crowe
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Undercapitalization?

Undercapitalization in terms of business means a scenario where a business faces a shortage of funds or capital requirements to continue its day-to-day operations. 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.

What Is Undercapitalization

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Undercapitalization (wallstreetmojo.com)

Undercapitalization can be a problem for any business, but it is generally prevalent for business units that are on a small scale. It is considered a vital 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. However, it can be solved by effective policies if implemented by the management.

Undercapitalization Explained

Undercapitalization occurs when companies earn higher profits at a lower rate than their peers operating in the same industry. It is a situation where the business lacks funds to support operations. It can also be a case where the value of assets a company holds is comparatively much higher than what the company has raised in capital. It is like the average rate of return in the industry is 10%. Still, the company is earning at the rate of 20% on its capital employed, making the company an undercapitalized business unit.

The condition may sometimes be a sign of mismanagement or poor financial planning, too much debt taken from lenders leading to repayment pressure and loss of valuable funds that could be used for potential investments or a fall in the company performance. A profit-earning entity needs to design the capital structure in such a way that it gives maximum return with minimum cost.

Undercapitalization can be a problem for any business, but it is generally prevalent for business units that 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 expanding or investing in other ventures. With sufficient capital, every firm will find it extremely difficult to venture into new areas or expand.

–>> Learn Professionally and Unleash Financial Insights! Join our ​Ratio Analysis Course​ for a dynamic 5+ hours packed with essential skills! From Profitability to Liquidity Ratios, dive into real-world case studies like Colgate. Elevate your financial prowess today!.

Example

Let us take a suitable example to understand the concept.

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

Undercapitalization Example

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Undercapitalization (wallstreetmojo.com)

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 an underestimation of the capital required, this also leads to undercapitalization because the company has a lack of capital to support its day to day operations.
  • Plow back profits methodology: A company has the policy of plowing 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 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 is estimated, the company may also go to a phase of undercapitalization.

Such causes can be controlled or minimized to some extent if the management is skilled and competent enough to implement proper strategies and methods to understand the type of business and the current market condition and then raise capital, keeping in mind the ideal capital structure suitable for the company, its overall cost and benefits.

Effects

The effects of the process can be far reaching and impact the company in many ways that are positive or negative. It is necessary to understand them in details so that the management may design strategies to tackle the same. Let us identify the situations as given below.

  • Undercapitalisation may, at times, force the management of the business to purposely bring about a change in numbers or manipulate the price of shares by adhering to unfair practices.
  • It leads to the growth of equity share in the market.
  • It may help increase the marketing potential of the shares because, during this phase, the EPS of the shares climbs and the dividend per share.
  • It may cause undue conflict between management and employees because employees see that the firm is earning more profit and thus may demand higher wages.
  • The financial obligation from the tax part may increase for the company because, during this phase, the company earns more, and the local tax authorities may tax this extra income.
  • Customers may feel cheated during this phase because as the company is earning more and profits are increasing, they may think that it is all happening due to the excess price charged by the company for the goods or services.
  • It may also cause more competitors to engage themselves in severe competition to earn more profits.
  • A scenario of excess trading may occur during the undercapitalization period where the company makes more money than it is financially capable of. As a result, the creditors will suffer due to untimely payment of the credit taken.
  • Undercapitalization is the predecessor to overcapitalization as the company generates excessive profits and reserves, also combined with debt financing.
  • Enhances the liquidity of investments because of the increased value of the shares, which can be sold anytime in the market on rising demand.

Remedies

  • Undercapitalization can be solved by incrementing the base value of a share or incrementing the number of equity shares by changing the value of the assets concerned upward. When this is done, the EPS goes down.
  • The other remedy which can be implemented is the issue of bonus shares to existing shareholders. This will also reduce the EPS without impacting the company’s total earnings.
  • It primarily occurs due to the shortage of capital; thus, one way to solve it is by issuing more equity shares or debentures as a common issue to the public.
  • Stock splits can also be applied in such scenarios, which increase the number of shares in the market but reduce the earnings per share.

Drawbacks

It is necessary to stay informed about the problems or drawbacks of any financial concept that commonly occur in the business so that proper steps can be taken on time to handle them. Given below are some important points to note.

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

Undercapitalization Vs Overcapitalization

The above are two different financial concepts that signify the financial structure of a business compared to the required capital and its value. Let us try to identify the differences between them as follows:

  • The former may lead to lack of resources or fund to meet the short term capital needs of the business which is not the case of the latter.
  • The former signifies that the company is not able to raise money from investors upto the level required to enable smooth running of the business, whereas the latter suggests that the company has raised funds that are more than the required amount.
  • Since there is lack of funds in the business in case of the former, there is less chance of investment into useful projects and assets. But in case of latter, there is the possibility of money being tied up in project that are not yielding enough return and thus not very profitable.
  • Due to the former, the company will not be able to expand or growth by entering new market with upgraded products and services or grabbing new opportunities that require funds. This is possible in case of the latter since there is more than enough availability of money with the company.
  • Companies that are undercapitalised will find it hard to tackle market downturns, economic slowdown or any kind of unexpected expense because they will not have the buffer funds to handle the same. But an overcapitalized business will not have this problem.
  • If a company is overcapitalized, it also means that it has borrowed a lot of money from investors resulting in a high debt or there is over issuance of equity to shareholders. This means there is lack of balance in the capital structure, resulting in an unnecessary pressure of repayment or payment to dividend which will again divert the resources away from profitable investments. But this is not the case with undercapitalized companies.
  • The former will have less chance of becoming the target for acquisition by big companies, but the latter has the chance of becoming the target because they have more assets which big companies will tr to sell off and invest the proceed for their own benefit.

Thus, we see that both the types of capital structures have their own features which may be favorable or unfavorable for the company and impact it in many ways, including its market position, competition with peers or investor’s faith.

Recommended Articles

This article has been a guide to what is Undercapitalization. We explain the differences with overcapitalization, its causes, effects with examples and remedies. You can learn more about it from the following articles –

Reader Interactions

Leave a Reply

Your email address will not be published. Required fields are marked *