What is Undercapitalization?

Undercapitalization occurs when a company does not have enough cash to conduct its operations.

How Does Undercapitalization Work?

Let's say Company XYZ is a jewelry company that begins getting huge orders from several national department stores. Company XYZ has to ramp up production and has to get some more factory space. However, it does not have the cash to do so, which means it is undercapitalized.

In some cases, a company can be so undercapitalized that it is running out of cash and thus can't pay its lenders.

Undercapitalization is a common problem and major threat among young and growing companies.

Why Does Undercapitalization Matter?

In many ways, being undercapitalized is a good problem to have, because it typically signals that there is demand for a company's product. However, if an undercapitalized company is unable to obtain funding quickly enough, it can see sales slump (in our example, the department stores are only going to wait a few weeks for their orders) and jeopardize the future of the company. Additionally, being in a rush for capital can mean that a company ends up paying a high interest rate or agrees to less than favorable terms for capital.

For these reasons, cash management and cash planning are crucial for virtually every company, regardless of size.

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Paul Tracy
Paul Tracy

Paul has been a respected figure in the financial markets for more than two decades. Prior to starting InvestingAnswers, Paul founded and managed one of the most influential investment research firms in America, with more than 3 million monthly readers.

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