Undercapitalization
Encyclopedia
Under-capitalization refers to any situation where a business
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, 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.
There are several different causes of undercapitalization , including:
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.
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,
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.
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
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.
The Federal Deposit Insurance Corporation
(FDIC) classifies banks according to their risk-based capital ratio:
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
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.
This can be caused by political instability, by lack of confidence in the rule of law
, by constraints on foreign direct investment
imposed by the government, or by other actions that discourage investment in certain industrial sectors. Examples:
Jeffry A. Frieden notes that during the period of European colonialism 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
. 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
, 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.
Business
A business is an organization engaged in the trade of goods, services, or both to consumers. Businesses are predominant in capitalist economies, where most of them are privately owned and administered to earn profit to increase the wealth of their owners. Businesses may also be not-for-profit...
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, which can trigger bankruptcy
Bankruptcy
Bankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. 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. 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
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 CPACertified Public Accountant
Certified Public Accountant is the statutory title of qualified accountants in the United States who have passed the Uniform Certified Public Accountant Examination and have met additional state education and experience requirements for certification as a 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 factoringFactoring (finance)Factoring is a financial transaction whereby a business job sells its accounts receivable to a third party at a discount...
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 placementPrivate placementPrivate placement is a funding round of securities which are sold without an initial public offering, usually to a small number of chosen private investors...
capital, venture capitalVenture capitalVenture capital is financial capital provided to early-stage, high-potential, high risk, growth startup companies. The venture capital fund makes money by owning equity in the companies it invests in, which usually have a novel technology or business model in high technology industries, such as...
, taking on a partner who makes a financial or "sweat equitySweat equitySweat equity is a term that refers to a party's contribution to a project in the form of effort --- as opposed to financial equity, which is a contribution in the form of capital....
" 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 deliberatelyundercapitalized 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
Deep Rock doctrine
Taylor v. Standard Gas Co. 306 U.S. 307 is an important case decided by the U.S. Supreme Court, which laid down the "Deep Rock doctrine" as a rule of bankruptcy and corporate law....
ensures that the parent corporation's claims are only settled after all other claims.
However, as decided in Walkovszky v. Carlton
Walkovszky v. Carlton
Walkovszky v. Carlton, 223 N.E.2d 6 , is a leading decision on the conditions under which Courts may pierce the corporate veil. A cab company had shielded themselves from liability by incorporating each cab as its own corporation...
, 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.The Federal Deposit Insurance Corporation
Federal Deposit Insurance Corporation
The Federal Deposit Insurance Corporation is a United States government corporation created by the Glass–Steagall Act of 1933. It provides deposit insurance, which guarantees the safety of deposits in member banks, currently up to $250,000 per depositor per bank. , the FDIC insures deposits at...
(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 Subprime mortgage crisis
Subprime mortgage crisis
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....
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.
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
Rule of law
The rule of law, sometimes called supremacy of law, is a legal maxim that says that governmental decisions should be made by applying known principles or laws with minimal discretion in their application...
, by constraints on foreign direct investment
Foreign direct investment
Foreign direct investment or foreign investment refers to the net inflows of investment to acquire a lasting management interest in an enterprise operating in an economy other than that of the investor.. It is the sum of equity capital,other long-term capital, and short-term capital as shown in...
imposed by the government, or by other actions that discourage investment in certain industrial sectors. Examples:
- In the electricity sector in ArgentinaElectricity sector in ArgentinaThe electricity sector in Argentina constitutes the third largest power market in Latin America. It relies mostly on thermal generation and hydropower generation , with new renewable energy technologies barely exploited. The country still has a large untapped hydroelectric potential...
, 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.
- In PakistanPakistanPakistan , officially the Islamic Republic of Pakistan is a sovereign state in South Asia. It has a coastline along the Arabian Sea and the Gulf of Oman in the south and is bordered by Afghanistan and Iran in the west, India in the east and China in the far northeast. In the north, Tajikistan...
, the textile industryTextile industryThe textile industry is primarily concerned with the production of yarn, and cloth and the subsequent design or manufacture of clothing and their distribution. The raw material may be natural, or synthetic using products of the chemical industry....
has been undercapitalized for decades. Among other factors, this is due to protectionist actions by the developed countries that should be natural markets for the industry's output. These include subsidies of locally produced raw materials (e.g. cotton in the USA), 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 CongoResource extraction in the Democratic Republic of CongoThe Democratic Republic of the Congo , previously known as Zaire, is immensely rich in natural resources. However, mining activities have been closely linked to serious problems in the DRC...
(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. Frieden notes that during the period of European colonialism 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
Comparative advantage
In economics, the law of comparative advantage says that two countries will both gain from trade if, in the absence of trade, they have different relative costs for producing the same goods...
. 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 Solow
Robert Merton Solow is an American economist particularly known for his work on the theory of economic growth that culminated in the exogenous growth model named after him...
, 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.
See also
- Banking
- BankruptcyBankruptcyBankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
- CapitalCapital (economics)In economics, capital, capital goods, or real capital refers to already-produced durable goods used in production of goods or services. The capital goods are not significantly consumed, though they may depreciate in the production process...
- Capital marketCapital marketA capital market is a market for securities , where business enterprises and governments can raise long-term funds. It is defined as a market in which money is provided for periods longer than a year, as the raising of short-term funds takes place on other markets...
- FinanceFinance"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
- InvestmentInvestmentInvestment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
- Mortgages
- Piercing the corporate veilPiercing the corporate veilPiercing the corporate veil or lifting the corporate veil is a legal decision to treat the rights or duties of a corporation as the rights or liabilities of its shareholders or directors. Usually a corporation is treated as a separate legal person, which is solely responsible for the debts it...