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Undercapitalization is the condition that occurs when a business lacks enough capital to fund its normal expenses and perform normal business activities. Undercapitalization therefore means that the company is unable to pay for its expenses and is unable to operate (Unless the undercapitalization can be rectified with another source of capital can be found – i.e. a loan). Though it can affect any business, undercapitalization is most common with small businesses and start-up companies. Poor planning and too-rapid expansion can result in negative cash flow, causing undercapitalization. A way to avoid undercapitalization is to create a realistic assessment of the company's expenses and projected financial needs. Based on this assessment, the business owner can draft a cash flow projection, which could help owners more accurately estimate the necessary funds to stay in operation and avoid undercapitalization. Even if a business is making profits, the owners must make sure that profits can be turned into cash to repay debts or else they risk undercapitalization. Undercapitalization can result in bankruptcy and/or personal liability for business-related matters. |
