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

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 employed, 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

  • 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

  • Undercapitalisation may, at times, force the management of the business to purposely bring about a change in numbers or manipulate with the price of shares by adhering to unfair practices.
  • It leads to the growth of equity share in the market.
  • It may help in increasing the marketing potential of the shares because, during this phase, the EPS of the shares climbs and also the dividend per share.
  • It may call fall 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 call fall more competitors engaging themselves in severe competition to earn more profits.
  • A scenario of excess trading may occur during the undercapitalization period where the company involves making more money than what it is financially capable of, and as a result of this, 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 account of rising demand.

Solutions

  • Undercapitalization can be solved by the increment of the base value of share or increment of the number of equity shares by changing the value of the assets concerned in an upward manner. 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 total earnings of the company.
  • 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 split can also be applied in such scenarios, which increase the number of share in the market but reduce the earnings per shares.

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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