Small Business Terms: What Is Undercapitalization?

by Craig Anthony

2 min read

Small businesses often struggle with managing cash flows. Small businesses that can’t stay ahead often run the risk of being undercapitalized. Fortunately, undercapitalization is not always a death sentence.

Defining Undercapitalization

The Small Business Encyclopedia at Entrepreneur.com has a good, practical definition of undercapitalization: “The condition that exists when a company doesn’t have enough cash to carry on its business and pay its creditors.”

Undercapitalization is not ideal, but does not necessarily mean that your business has to close its doors. For example, imagine a boutique sunglasses maker in Ontario that starts to receive large orders from a multinational department store. The shop owner realizes that they do not have the capacity to fill the orders, but the business simply doesn’t have the cash on hand to expand. In this circumstance, the company is undercapitalized.

However, the shop owner could take out a loan or seek out investors to quickly build up the company’s financial capital with the expectation that future receipts will be large enough to compensate the capital providers.

Causes of Undercapitalization

Businesses run out of money for many reasons. Some fail to properly plan for customer demand or an increase in operating expenses. Others make costly mistakes around tax time. Some make investments that don’t pan out, or may suffer a catastrophic accident without proper insurance.

Effects of Undercapitalization

On one hand, undercapitalization is a substantial problem. Businesses need operating capital to pay staff, keep machines in working order, pay rent, settle up with creditors, and market to new customers. The risk is that everything unravels when there isn’t enough liquidity. On the other hand, an undercapitalized business could be a great spot. Often time, a lack of cash flow is a sign of high demand for products or services.

If your business is undercapitalized, all that means is that you are at a crossroads. You can be proactive and renegotiate with lenders, acquire new investors or find new creditors, or find ways to streamline your operations. If you do this successfully, you may end up better off than before. If not, it may be a sign that your business is not strong enough to survive.

Avoiding Undercapitalization

If you are starting (or thinking about starting) a new business, here are some quick tips on avoiding undercapitalization down the road.

  1. Find a Partner or Mentor Who Can Keep You Accountable. This is particularly good advice for those who love being their own boss. Even CEOs of multinational conglomerates rely on a board of directors, so there is no reason to think you shouldn’t rely on an advisor of sorts to help you avoid expensive mistakes.
  2. Start In a Sector or Industry You Know. If you are an expert in your given field, then you should have a better idea about how much working capital your business needs for startup costs, cash flow, and future budgeting.
  3. Prepare a Professional Business Plan. A great business plan can help you start off on the right foot and stay on track. Just as importantly, it can help attract new investors or lenders whenever you need extra capital down the road.

References & Resources

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