Undercapitalization occurs when a business cannot finance itself sufficiently, leading to bankruptcy. This can happen due to declining sales or a lack of initial funding. Companies must adapt or seek outside assistance to correct this status and remain viable.
Undercapitalization is a condition that results in the inability to finance a business venture sufficiently. Essentially, the amount of revenue generated and other resources in control of the business are not sufficient to cover the ongoing operating costs associated with the enterprise. When a company lacks the capital to sustain production at a profitable level, the business is immediately in danger of bankruptcy and possibly dissolution.
There are several situations that can lead to an undercapitalized status for a company. When changes in consumer habits make the more profitable products manufactured by the company undesirable, declining sales may not be enough to offset operating costs. To correct the undercapitalization status, the company will have to reduce production of obsolete products to serve a smaller market or develop new products that will be able to attract the attention of a new consumer market.
A second scenario that can turn into a lack of sufficient capital concerns a start-up. In general, a new company will attempt to secure support providing resources to cover operating costs until the company can begin generating revenue and making a profit. When the new company fails to attract enough business to meet production costs on schedule, the firm will be considered undercapitalized. At this point, investors have the choice to invest additional resources in the company or cut losses and exit the business.
Many companies will experience at least one phase of undercapitalization at one time or another. Often times, the lack of funding capital is often on the front end, while the business is still building a viable customer base. A temporary period of undercapitalization will occur unless the business plan accurately forecasts the amount of funding needed to support the business until profitability is achieved.
Other times, changes in consumer tastes or advances in technology will trigger a period in which the company must adapt to remain profitable. During this transition, the company may need to seek outside assistance in order to make the necessary changes to remain a viable entity, or at least cash in on assets that are not essential for the core operation to continue. Without correction of this undercapitalization status, the company will fail to make it through this transitional period and will eventually fail.
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