Recently updated on April 13th, 2023 at 06:39 pm
Under capitalization refers to any situation where a business cannot acquire the funds they need. An under-capitalized 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.
A company is said to be under-capitalised when it is earning exceptionally higher profits as compared to other companies or the value of its assets is significantly higher than the capital raised. For instance, the capitalisation of a company is Rs. 20 lakhs and the average rate of return of the industry is 15%. But if the company is earning 30% on the capital investment, it is a case of under-capitalisation.
Causes of under-capitalization
Under-capitalization 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:
- 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.
Creation of Secret Reserves:
A company may have large secret reserves due to which its profitability is higher.
Conservative Dividend Policy:
The management may follow a conservative dividend policy leading to higher rate of ploughing back of profits. This would increase the earning capacity of the company.
Acquisition of Assets during Recession:
Assets might have been acquired at low costs during necessary conditions in the market. And now higher incomes are being earned by their use.
The management of a company may be highly efficient. It may issue the minimum share capital and may meet the additional financial requirements through borrowings at lower rates of interest.
Under-estimation of Requirements:
There may be under-estimation of capital requirements of the company by the promoters. This may lead to capitalisation which is insufficient to conduct its operations.
Effects of Under-capitalization on Society:
- Because of higher profits, the consumers feel exploited. They link higher profits with higher prices of the products.
- Under-capitalisation may lead to higher profits and higher prices of shares on the stock exchange. This may encourage unhealthy speculation in its shares.
- The management of the company may build up secret reserves and pay lower taxes to the Government.
Effects of Under-capitalization on Shareholders:
- The value of its equity share in the market will go up.
- The profitability of the company may be very high. As a result, the rate of earnings per share will go up.
- The shareholders can expect higher dividends regularly.
- The financial reputation of the company will increase in the market.
Effects of Under-capitalization on Company:
- The management may be tempted to build up secret reserves.
- Because of higher profitability, the market value of company’s shares would go up. This would also increase the reputation of the company.
- Higher rate of earnings will attract competition in the market.
- If a company is earning higher profits, the customers may feel that they are being overcharged by the company.
- The workers of the company may be tempted to demand higher wages, bonus and other benefits.
- The government may increase tax rates on companies earning exceptional profits.
- Fresh share capital can be raised via the primary capital market to curb undercapitalization. If under-capitalisation is due to inadequacy of capital, then it can be corrected by the issue of fresh shares, the company may also redeem its long-term debt by the issue of fresh share capital.
- A company may decide to go for a stock split which would eventually display a reduction in dividend per share and earnings per share.
- A company may issue bonus shares which would have the same effect as in the previous point. The company may issue bonus shares by capitalising its accumulated earnings. This is the most commonly used and effective method of correcting under-capitalisation. It reduces earnings per share after the bonus issue.
- Startups and small businesses should prepare monthly cash flow projections & equity forecasts to avoid being undercapitalized.