Under-capitalization refers to any situation where a

business Business is the practice of making one's living or making money by producing or Trade, buying and selling Product (business), products (such as goods and Service (economics), services). It is also "any activity or enterprise entered into for ...

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 Bankruptcy is a legal process through which people or other entities who cannot repay debts to creditors may seek relief from some or all of their debts. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the deb ...

, 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.

Causes of under-capitalization

Under-capitalization is often a result of improper

financial planning In general usage, a financial plan is a comprehensive evaluation of an individual's current pay and future financial state by using current known variables to predict future income, asset values and withdrawal plans. This often includes a budg ...

. 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 Investment is traditionally defined as the "commitment of resources into something expected to gain value over time". If an investment involves money, then it can be defined as a "commitment of money to receive more money later". From a broade ...

. There are several different causes of undercapitalization, including: *Financing growth with short-term capital, rather than permanent capital *Failing to secure an adequate

bank loan In finance, a loan is the tender of money by one party to another with an agreement to pay it back. The recipient, or borrower, incurs a debt and is usually required to pay interest for the use of the money. The document evidencing the debt ( ...

at a critical time *Failing to obtain insurance against predictable business risks *Adverse

macroeconomic Macroeconomics is a branch of economics that deals with the performance, structure, behavior, and decision-making of an economy as a whole. This includes regional, national, and global economies. Macroeconomists study topics such as output/ GDP ...

conditions 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 is not 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, * 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, long-term 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 Private placement (or non-public offering) is a funding round of securities which are sold not through a public offering, but rather through a private offering, mostly to a small number of chosen investors. Generally, these investors include frien ...

capital,

venture capital Venture capital (VC) is a form of private equity financing provided by firms or funds to start-up company, startup, early-stage, and emerging companies, that have been deemed to have high growth potential or that have demonstrated high growth in ...

, 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.

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.

Banking industry

In the banking industry, undercapitalization refers to having insufficient capital to cover foreseeable risks.

United States

The

Federal Deposit Insurance Corporation The Federal Deposit Insurance Corporation (FDIC) is a State-owned enterprises of the United States, United States government corporation supplying deposit insurance to depositors in American commercial banks and savings banks. The FDIC was cr ...

(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

subprime mortgage crisis The American subprime mortgage crisis was a multinational financial crisis that occurred between 2007 and 2010, contributing to the 2008 financial crisis. It led to a severe economic recession, with millions becoming unemployed and many busines ...

has shown that banks and other mortgage issuers in the US 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 the

2008 financial crisis The 2008 financial crisis, also known as the global financial crisis (GFC), was a major worldwide financial crisis centered in the United States. The causes of the 2008 crisis included excessive speculation on housing values by both homeowners ...

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 The essence of the rule of law is that all people and institutions within a Body politic, political body are subject to the same laws. This concept is sometimes stated simply as "no one is above the law" or "all are equal before the law". Acco ...

, by constraints on

foreign direct investment A foreign direct investment (FDI) is an ownership stake in a company, made by a foreign investor, company, or government from another country. More specifically, it describes a controlling ownership an asset in one country by an entity based i ...

imposed by the government, or by other actions that discourage investment in certain industrial sectors. Examples: * In the

electricity sector in Argentina The electricity sector in Argentina constitutes the third largest power market in Latin America. It relies mostly on thermal generation (60% of installed capacity) and hydropower generation (36%). The prevailing natural gas-fired thermal genera ...

, 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 Pakistan, officially the Islamic Republic of Pakistan, is a country in South Asia. It is the List of countries and dependencies by population, fifth-most populous country, with a population of over 241.5 million, having the Islam by country# ...

, the

textile industry The textile industry is primarily concerned with the design, production and distribution of textiles: yarn, cloth and clothing. Industry process Cotton manufacturing Cotton is the world's most important natural fibre. In the year 2007, th ...

has been undercapitalized for decades. Among other factors, this is due to

protectionist Protectionism, sometimes referred to as trade protectionism, is the economic policy of restricting imports from other countries through methods such as tariffs on imported goods, import quotas, and a variety of other government regulations. ...

actions by the

developed countries A developed country, or advanced country, is a sovereign state that has a high quality of life, developed economy, and advanced technological infrastructure relative to other less industrialized nations. Most commonly, the criteria for eval ...

that should be natural markets for the industry's output. These include

subsidies A subsidy, subvention or government incentive is a type of government expenditure for individuals and households, as well as businesses with the aim of stabilizing the economy. It ensures that individuals and households are viable by having acce ...

of locally produced raw materials (e.g. cotton in the US), subsidies on local textile industries and high import

tariffs A tariff or import tax is a duty imposed by a national government, customs territory, or supranational union on imports of goods and is paid by the importer. Exceptionally, an export tax may be levied on exports of goods or raw materials and is ...

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. FriedenJeffry A. Frieden: Global Capitalism - Its Fall and Rise in the Twentieth Century. Norton 2006 notes that during the period of

European colonialism The phenomenon of colonization is one that stretches around the globe and across time. Ancient and medieval colonialism was practiced by various civilizations such as the Phoenicians, Babylonians, Persians, Greeks, Romans, Han Chinese, and Ar ...

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 Import substitution industrialization (ISI) is a protectionist trade and economics, economic policy that advocates replacing foreign imports with domestic production. It is based on the premise that a country should attempt to reduce its foreign ...

which diverted capital from other enterprises where these countries had a

comparative advantage Comparative advantage in an economic model is the advantage over others in producing a particular Goods (economics), good. A good can be produced at a lower relative opportunity cost or autarky price, i.e. at a lower relative marginal cost prior t ...

. 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 Robert Merton Solow, GCIH (; August 23, 1924 – December 21, 2023) was an American economist who received the 1987 Nobel Memorial Prize in Economic Sciences, and whose work on the theory of economic growth culminated in the exogenous growth ...

, 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.

Footnotes

References

*Van Horn, Mike (2006) ''Build a Culture of Profitability'' Oakland: The Encounter Collaborative
FDIC Federal Deposit Insurance Act
*Robert Solow: Capital Theory and the Rate of Return. 1963.