Undercapitalization

Undercapitalization refers to any situation where a business cannot acquire the funds they need. An undercapitalized business may be one that cannot afford current operational expenses due to a lack of capital, which can trigger bankruptcy, 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 undercapitalization

Undercapitalization is often a result of improper financial planning. 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.

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 conditions

An example of undercapitalization caused by growth financed with short-term capital can be seen in the 1998 failure of a popular graphic design business in Oakland, California. After its popularity warranted expansion, the owner applied for a bank loan, but failed to get it. The owner decided to finance her business growth using low-interest offers on various low interest credit cards, i.e. short term capital. During a summer lull, several late payments triggered a massive interest rate increase. Despite her growing and profitable business, this huge increase in the cost of capital forced her to declare bankruptcy.

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.

Banking industry

In the banking industry, undercapitalization refers to having insufficient capital to cover foreseeable risks. The Federal Deposit Insurance Corporation (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 Template:As of Subprime mortgage crisis has shown that banks and other mortgage issuers in the USA 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 a global financial crisis during 2007-2008.

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.