Undercapitalization: Definition and Explanation

Undercapitalization occurs when a company has insufficient capital but a large secret reserve.

Generally, the value of land and buildings, plant, machinery, and goodwill appreciate over time, but companies do not show this in their accounts. These assets may earn a substantial return, which results in a larger amount of profit compared to the initial capital investment.

In the case of undercapitalization, the full capacities of the enterprise cannot be exploited due to the shortage of funds. The rate of dividends and the value of shares are higher than the rate of dividends and the value of shares in similar companies.

Example

Suppose that the normal rate of return in an industry is 15%. A company in this industry earns a profit of $3,000,000 and has an amount of employed capital totaling $10,000,000.

The proper capital of the company for this profit of $3,000,000 should be $20,000,000. The company has been earning the same profit with a capital of $10,000,000.

In this case, the company is undercapitalized to the extent of $10,000,000.

Undercapitalized companies earn profit at considerably higher rates compared to similar companies in the same industry. Undercapitalization can be compared to a lean, thin, and weak person who cannot run effectively due to this weakness.

Disadvantages of Undercapitalization

Undercapitalized companies suffer from the following disadvantages.
(i) Conflict between labor and management: A higher rate of earning may cause workers to demand a wage increase. If management does not meet these demands, a conflict between labor and management may arise.
(ii) Consumers may feel exploited: Declaring a dividend at a higher rate creates a feeling among consumers that they are being exploited. This is because, instead of decreasing the price, the company has increased the dividend.
(iii) Manipulation of share value: Managers may use undercapitalization to manipulate share value and, in this way, exploit shareholders.
(iv) Higher rates of taxation: Earnings at a higher rate attract the government’s attention, which results in higher rates of taxation.

Effects of Undercapitalization on Shareholders

1. Higher rate of returns: In the case of undercapitalization, the rate of return payable to shareholders is higher. Dividends are also paid at higher rates.
2. Higher share value: Due to the larger dividend that the company declares, the share price will increase.
3. Increased liquidity of investments: A higher share value increases their liquidity. These shares can be sold whenever required due to their increasing market price.

Solutions to Limit the Negative Impact of Undercapitalization

The following measures should be adopted as remedial measures to limit the negative impact of undercapitalization:
(i) Increase the number of shares: Under this scheme of reorganization, the number of shares is increased, which results in a reduction of the dividend per share.
(ii) Increase the par value of shares: Under this method, the par values of shares are increased so that the rate of dividend declines, but the dividend per share remains the same.
(iii) Issue bonus shares: Issue of bonus shares increases the number of shares, and so the dividend per share and the rate of dividend fall.

Undercapitalization has negative consequences, but these are not as fatal as those associated with overcapitalization. Even so, efforts should be made to reduce the pressure of undercapitalization.

Frequently Asked Questions

What is under capitalization?

Under capitalization is the state of affairs of a business, notably in terms of equity capitalization, where there is an excess surplus of assets over the legal requirement of assets.

How does undercapitalization affect shares?

Shares of companies with large amounts of cash are often perceived as more valuable. This is because a company with a larger amount of cash has more flexibility to make investments and acquisitions that could create value for shareholders.

Does undercapitalization affect dividends?

A high dividend payout ratio can often signal undercapitalization. Undercapitalized companies often face challenges in funding their day-to-day Operating Expenses. This forces them to rely on high dividend payouts, which often signal a lack of investment opportunities for the company's capital.

What are the advantages of undercapitalization?

The advantages of undercapitalization are as follows:- the dividends per share are high - higher rates of return relative to similar companies in the industry

What are the disadvantages of undercapitalization?

The disadvantages of undercapitalization are as follows:- labor–management conflicts may arise over wage disputes.- Consumers might perceive high rates of dividend payments to be an exploitation of consumers. - Dividends per share may decline over time, resulting in lower rates of return relative to peer companies or industry benchmarks. - Declining dividends per share could have a negative impact on employees as employees who are paid fixed salaries might feel that their wages are less important than dividends to the company.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

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