Undercapitalization is a situation when an organization lacks the availability of funds needed to conduct regular business. Undercapitalization is especially common and detrimental to small businesses (SMB). Without proper funds, a company cannot afford daily operational expenses and is at risk for bankruptcy.
Undercapitalization can usually be attributed to incorrect financial planning and management. While it’s common for costs to be deferred in business, lack of capital is not usually an issue as long as cash flow is consistent and expenses are paid within a reasonable amount of time. When cash flow lags, the company can go into debt, be unable to pay employees, lose productivity and risk bankruptcy.
A few causes of undercapitalization can include:
- Inadequate planning for predictable business risks
- Unfavorable macroeconomic circumstances
- Funding growth with short-term funds instead of permanent finds
- Failure to raise enough capital from a variety of sources, such as a bank loan, venture capital or on credit
At the very least, undercapitalization can mean missed opportunities. Some business ventures or opportunities may require an increase in initial expenditure for long-term return on investment (ROI). An undercapitalized company can miss out on unexpected opportunities if no extra funds are available. For these reasons, undercapitalization often leads to reduced profits for many startups and small businesses.
Accurate expense forecasting can help ensure funds aren’t lower than expected, protecting against undercapitalization. Conservative and careful spending can help at-risk businesses manage fluctuations in income. A contingency or “rainy day” fund can also help cover costs of unforeseen expenses.