undercapitalization

Undercapitalization refers to any situation where a business cannot acquire the funds they need. An undercapitalized business may be one that cannot afford current operational expenses due to a lack of capital, which can trigger bankruptcy, may be one that is over-exposed to risk, or may be one that is financially sound but does not have the funds required to expand to meet market demand.
Content

1 Causes of Undercapitalization 2 Capital sources 3 Bankruptcy of an Undercapitalized Subsidiary 4 Banking Industry 5 Macroeconomics 6 Footnotes 7 References 8 See also

[edit]Causes

of Undercapitalization

Undercapitalization is often a result of improper financial planning. However, a viable business may have difficulty raising sufficient capital during an economic downturn or in a country that imposes artificial constraints on capital investment. There are several different causes of undercapitalization [1], including:

Financing growth with short-term capital, rather than permanent capital Failing to secure an adequate bank loan at a critical time Failing to obtain insurance against predictable business risks Adverse macroeconomic conditions

An example of undercapitalization caused by growth financed with shortterm capital can be seen in the 1998 failure of a popular graphic design business in Oakland, California. After its popularity warranted expansion, the owner applied for a bank loan, but failed to get it. The owner decided to finance her business growth using low-interest offers on various low interest credit cards, i.e. short term capital. During a summer lull, several

late payments triggered a massive interest rate increase. Despite her growing and profitable business, this huge increase in the cost of capital forced her to declare bankruptcy. Accountants can structure the financials in order to minimize profit, and thus taxes. As a business grows, this approach becomes counterproductive (Van Horn 2006). Frequently, a growing business will apply for a bank loan only to find their entire accounting system under review.

Capital sources
A manual on collecting capital, by CPA David Levinson, states that one solid approach to assuring capital is to establish a line of credit, borrow against it, even if it isnt needed, then pay back this loan. Doing this repeatedly can help a business owner expand their capital when they need to increase their credit or take out a larger loan (Levinson 1998). A business may acquire capital through re-investment of earnings, through assuming debt or through selling equity. According to Van Horn[2],

The least expensive ways to raise capital are to finance from cash flow, and to improve cash flow through regular invoicing, collecting overdue receivables, stretching payables without incurring interest or penalties, renegotiating loans for lower interest rates and exploiting trade discounts. Debt is more expensive. The cost of debt is lowest with secured, longterm loans or use of personal savings, higher with unsecured loans, credit card loans and cash advances, and with factoring accounts receivable. Equity financing is most expensive, and dilutes the value of existing owners' shares in the business. It may be the only option if a business has good prospects but insufficient assets to secure loans. Equity capital may be raised through additional investments from existing partners or stockholders, private placement capital, venture capital, taking on a partner who makes a financial or "sweat equity" investment, or issuing additional shares.

Undercapitalization may result from failure of a business to take advantage of these capital sources, or from inability to raise capital using any of these sources.

[edit]Bankruptcy

of an Undercapitalized Subsidiary

When a subsidiary of a corporation files for bankruptcy, there may be reason to suspect that it was deliberately undercapitalized and mismanaged for the benefit of the parent corporation. The main cause of failure may have been excessive payments to the parent for goods or services provided by the parent, or inadequate charges for goods or services provided to the parent. In effect, capital provided by other investors was channeled to the parent corporation until the subsidiary failed. These cases can be extremely difficult to prove, but the Deep Rock doctrine ensures that the parent corporation's claims are only settled after all other claims. However, as decided in Walkovszky v. Carlton, the parent corporation is not responsible for settling claims in excess of remaining assets when an undercapitalized subsidiary fails. [edit]Banking

Industry

In the banking industry, undercapitalization refers to having insufficient capital to cover foreseeable risks. The Federal Deposit Insurance Corporation (FDIC) classifies banks according to their risk-based capital ratio:

Well capitalized: 10% or higher Adequately capitalized: 8% or higher Undercapitalized: less than 8% Significantly undercapitalized: less than 6% Critically undercapitalized: less than 2%

When a bank becomes undercapitalized the FDIC issues a warning to the bank. When the number drops below 6% the FDIC can change management and force the bank to take other corrective action. When the bank becomes critically undercapitalized the FDIC declares the bank insolvent and can take over management of the bank. The current Subprime mortgage crisis has shown that banks and other mortgage issuers in the USA were undercapitalized, failing to ensure that they had sufficient capital or insurance to cover the risk of mortgage defaults in the event of the bursting of a housing price bubble. Since the affected institutions were important sources of capital to other industries, this triggered a global financial crisis during 2007-2008.

[edit]Macroeconomics A country or sector of the economy may be undercapitalized in the sense that businesses in that country or sector are handicapped by lack of affordable investment funds. This can be caused by political instability, by lack of confidence in the rule of law, by constraints on foreign direct investment imposed by the government, or by other actions that discourage investment in certain industrial sectors. Examples:

In the electricity sector in Argentina, the government introduced controls on energy prices in 2002, reducing profitability and thus discouraging capital investment. This was compounded by high inflation, which caused declines in real revenue, while devaluation of the peso increased the cost of servicing high levels of debt in foreign currency. The result was severe undercapitalization, which led to inability to keep up with increasing demand, contributing to the 2004 Argentine energy crisis. In Pakistan, the textile industry has been undercapitalized for decades. Among other factors, this is due to protectionist actions by the developed countries that should be natural markets for the industry's output. These include subsidies of locally produced raw materials (e.g. cotton in the USA), subsidies on local textile industries and high import tariffs on goods manufactured in Pakistan and other low-cost garment producers. Resource extraction in the Democratic Republic of Congo (e.g. mining) has been undercapitalized for many years due to endemic violence and looting, uncertain property rights and concerns about corruption. Although the potential is huge, the risks are also huge. Only the bravest investor would supply capital in this environment.

Jeffry A. Frieden[3] notes that during the period of European colonialism the colonial powers encouraged investment in production of raw materials while discouraging investment in industries that would use these materials as inputs in competition with the colonial power's home industries. During the same period, independent developing countries in Latin America and other areas pursued a policy of Import substitution industrialization which diverted capital from other enterprises where these countries had a comparative advantage. Although opposite in intent, both

policies had the effect of creating overcapitalization in some sectors and undercapitalization in others. A contrary view comes from the economist Robert Solow, who was awarded the Nobel prize for his work on the ways in which labor, capital and technical progress contribute to overall economic growth. Among other insights, Solow showed that undercapitalization appears to have less impact on economic growth than would be predicted by earlier economic theories.

Undercapitalization
What Does Undercapitalization Mean? 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 longterm debt.

Investopedia explains Undercapitalization Being undercapitalized is a trait most often found in young companies that do not adequately anticipate the start-up costs associated with getting a business up and running. 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 the company has sufficient cash flows, it can replenish it coffers by issuing stock or debt, or obtaining a long-term revolving credit arrangement with a lending group. 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 Under-capitalization is just the reverse of over-capitalization. A company is considered to be under-capitalized when its actual capitalization is lower than its proper capitalization as warranted by its earning capacity. Causes of under- capitalization 1. Under estimation of future earnings of the time of promotion of the company. 2. Abnormal increase in earnings from new economic and business environment. 3. Under estimation of total funds requirements. 4. Maintaining very high efficiency through improved means of production of goods or rendering of services. 5. Companies which are set up during recession start making higher earning capacity as soon as the recession is over. 6. Use of low capitalized rate. 7. Companies which follow conservative dividend policy will achieve a process of gradually rising profits. 8. Purchase of assets at exceptionally low prices during recession. Remedies of undercapitalization 1. Splitting up at the shares This will reduce the dividend per share 2. Issue of bonus share: this will reduce both the dividend per share and earning per share. 3. Both over-capitalization and under capitalization are detrimental to the interests of the society.

Undercapitalization and Small Businesses

The seriousness of undercapitalization and ways you can avoid it in your business
Undercapitalization is any circumstance where a business owner can not acquire the funds they need. This is generally the case when the business can not afford the current operational expenses because their short term capital is not enough. When capital is low and expenses are still due, this can often times lead to bankruptcy. When businesses are not financially stable this can result in undercapitalization. Most reasons than others, it is because the fault of the business owner. There are companies such as American Express, the Business Group, and Y.P.O. who have made an industry out of foreseeing the causes of undercapitalization and offer there services too businesses for a fee. However, this service usually only works for people who want to continue having a secure business and want a fall back plan in case something does happen. Companies that already have undercapitalization problems may not benefit from this service. There are reasons why business does not have complete revenue assurance. The main two reasons behind the problems are because 1) the financing growth is from short term capital rather than permanent capital, and 2) failure to secure an adequate bank loan at a critical time. These two situations can greatly damage your business in the long run. Financial business growth is best financed through permanent capital. Short term capital may be revolving credit, credit cards, and factoring accounts received. Many new small business owners often make the mistake of not

using permanent undercapitalization.

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Though undercapitalization problems generally happen to new businesses in their first year, it can happen in other years. If the beginning growth of the business was rapid but profits are fairly passive, then you may be setting yourself up for undercapitalization problems. There are ways to avoid this problem though.

Get proactive in your planning process. Make sure that you current business plan and any future changes have a just in case plan based on the growth of your business. If you business begins to grow too fast, have a plan B for incase a sudden decrease in revenue occurs. Find an investor; this can be a trustworthy relative or friend, who can act as a pinch investor. This is someone who can bail you out in case of a dramatic business slump. Get a line of credit at the bank Always have an emergency plan. This can go as far as selling some of your personal assets, such as your car. Many people rather want to see a personal asset be taken away from them than for their business to be taken away. Raise your prices to stem the tide of customers Review your expenses at the end of each month and make changes if needed.

It is very important for business owners, especially new business owners to have a business plan that ensures their business assurance. Many business owners find it beneficial to obtain secured or unsecured business loans and cash advances from companies. This helps the financial stability of your company, and helps with undercapitalization problems.

One of the EFFECTS OF UNDER CAPITALIZATION is that the market value of shares goes up. But still under capitalization is not considered good for the Co. Why? Effects of under capitalization on the company: (increases, goodwill, credit worthiness competition and demand for higher salaries)

Increases creditworthiness and goodwill of the company as market value of shares goes up due to high profitability An under capitalized company earns more than the prevailing rate of profit in the industry. But this may induce competitors to enter the same line of business and pose a threat to the company. The employees demand higher salaries, which may lead to dissatisfaction and labour tension. Secret reserves are built. Exceptionally high rate of profit may induce Government to impose heavy tax, which leads to reduction in company profits.

under capitalization
Hide links within the definition Definition Situation where a business does not have sufficientstockholders' funds for its size of operations. An undercapitalized firm does not have enough cash to carryout its functions and usually does not qualify for bankor other loans due to its unacceptably high loan-to-equityratio. Under capitalization is one of the major causes of business startup failures.