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 pr ...

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 Capital may refer to: Common uses * Capital city, a municipality of primary status ** List of national capital cities * Capital letter, an upper-case letter Economics and social sciences * Capital (economics), the durable produced goods used f ...

, 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 debtor ...

, 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 bu ...

. However, a viable business may have difficulty raising sufficient capital during an

economic downturn In economics, a recession is a business cycle contraction when there is a general decline in economic activity. Recessions generally occur when there is a widespread drop in spending (an adverse demand shock). This may be triggered by various ...

or in a country that imposes artificial constraints on

capital investment Investment is the dedication of money to purchase of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort. In finance, the purpose of investing is ...

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

macroeconomic Macroeconomics (from the Greek prefix ''makro-'' meaning "large" + ''economics'') is a branch of economics dealing with performance, structure, behavior, and decision-making of an economy as a whole. For example, using interest rates, taxes, and ...

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 isn’t 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 friend ...

capital,

venture capital Venture capital (often abbreviated as VC) is a form of private equity financing that is provided by venture capital firms or funds to startups, early-stage, and emerging companies that have been deemed to have high growth potential or which ha ...

, 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 ''Taylor v. Standard Gas and Electric Company'', 306 U.S. 307 (1939), was an important Supreme Court of the United States, United States Supreme Court case in United States corporate law that laid down the "Deep Rock doctrine" as a rule of bankrup ...

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 one of two agencies that supply deposit insurance to depositors in American depository institutions, the other being the National Credit Union Administration, which regulates and insures cred ...

(FDIC) classifies banks according to their risk-based

capital ratio Capital Adequacy Ratio (CAR) is also known as ''Capital to Risk (Weighted) Assets Ratio'' (CRAR), is the ratio of a bank's Financial capital, capital to its risk. Bank regulation, National regulators track a bank's CAR to ensure that it can absorb ...

: *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 United States subprime mortgage crisis was a multinational financial crisis that occurred between 2007 and 2010 that contributed to the Financial crisis of 2007–2008, 2007–2008 global financial crisis. It was triggered by a large decline ...

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 An economic bubble (also called a speculative bubble or a financial bubble) is a period when current asset prices greatly exceed their intrinsic valuation, being the valuation that the underlying long-term fundamentals justify. Bubbles can be c ...

. Since the affected institutions were important sources of capital to other industries, this triggered a global financial crisis during 2007-2008.

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 rule of law is the political philosophy that all citizens and institutions within a country, state, or community are accountable to the same laws, including lawmakers and leaders. The rule of law is defined in the ''Encyclopedia Britannica ...

, by constraints on

foreign direct investment A foreign direct investment (FDI) is an investment in the form of a controlling ownership in a business in one country by an entity based in another country. It is thus distinguished from a foreign portfolio investment by a notion of direct co ...

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 The Argentine energy crisis was a natural gas supply shortage experienced by Argentina in 2004. After the recession triggered by the Argentine economic crisis (1999-2002), Argentina's energy demands grew quickly as industry recovered, but extracti ...

. * In

Pakistan Pakistan ( ur, ), officially the Islamic Republic of Pakistan ( ur, , label=none), is a country in South Asia. It is the world's List of countries and dependencies by population, fifth-most populous country, with a population of almost 24 ...

, the

textile industry The textile industry is primarily concerned with the design, production and distribution of yarn, cloth and clothing. The raw material may be natural, or synthetic using products of the chemical industry. Industry process Cotton manufacturi ...

has been undercapitalized for decades. Among other factors, this is due to protectionist actions by the

developed countries A developed country (or industrialized country, high-income country, more economically developed country (MEDC), advanced country) is a sovereign state that has a high quality of life, developed economy and advanced technological infrastruct ...

that should be natural markets for the industry's output. These include subsidies of locally produced raw materials (e.g. cotton in the US), subsidies on local textile industries and high import tariffs 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 historical phenomenon of colonization is one that stretches around the globe and across time. Ancient and medieval colonialism was practiced by the Phoenicians, the Greeks, the Turkish people, Turks, and the Arabs. Colonialism in the mode ...

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 which diverted capital from other enterprises where these countries had a

comparative advantage In an economic model, agents have a comparative advantage over others in producing a particular good if they can produce that good at a lower relative opportunity cost or autarky price, i.e. at a lower relative marginal cost prior to trade. Comp ...

. 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 (; born August 23, 1924) is an American economist whose work on the theory of economic growth culminated in the exogenous growth model named after him. He is currently Emeritus Institute Professor of Economics at the Ma ...

, 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.