Undercapitalization Definition Example Top Causes

Undercapitalization Definition

Explanation

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.

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How does it Work?

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 very high that what the company has raised in capital. It is like suppose the average rate of return in the industry is 10%. Still, the company is 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, making 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. 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.

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.

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 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 sharesEPS Of The SharesEarnings Per Share (EPS) is a key financial metric that investors use to assess a company’s performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is.read more 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 overcapitalizationOvercapitalizationOvercapitalization refers to a scenario wherein a Company raises a capital amount that is way more than the worth of its fixed assets. It means that a Company’s capitalized value becomes more than that of its actual market value. read more as the company generates excessive profits and reserves, also combined with debt financing.Enhances the liquidityLiquidityLiquidity is the ease of converting assets or securities into cash.read more of investments because of the increased value of the shares, which can be sold anytime in the market on rising demand.

Solutions

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 sharesBonus SharesBonus shares refer to the stocks issued by the companies for free of cost to their existing shareholders in the proportion of their stock holdings. Companies issue such shares to compensate the shareholders with a higher dividend payout in the form of stocks.read more 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 debenturesDebenturesDebentures refer to long-term debt instruments issued by a government or corporation to meet its financial requirements. In return, investors are compensated with an interest income for being a creditor to the issuer.read more as a common issue to the public.Stock splitStock SplitStock splits refer to the process whereby a company increases its number of shares, reducing the per-share price of the stocks. read more can also be applied in such scenarios, which increase the number of shares in the market but reduce the earnings per share.

Drawbacks

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.

Conclusion

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.