What is Under Capitalization and how it can affect your Business?
14

Jan 2021

The importance of capital is known to every businessman. The way the capital of a business is structured plays a very important role in the growth and development of a business. a good capital structure of a business not only helps the management of the business in many ways but also affects the workers and the shareholders of the company.

In this blog, we will understand what undercapitalization is and how it can affect your business.

Under Capitalization: Meaning

Undercapitalization refers to a situation in which the company cannot furnish enough capital to conduct normal business activities. This can happen due to various reasons and will affect the profitability of the company as well as the efficiency of the workers.

In most of the cases, a company that faces the case of undercapitalization tend to choose sources of capital that are high in interest and cost such as short term credit instead of long term debt or any equity. This will increase the chances of the bankruptcy of the company which in turn tends to attract fewer investors.

Most of the undercapitalized companies tend to miscalculate the costs that will be incurred to set up and run a business. Also, the management is unable to figure out the basic day to day costs associated with a business. This phenomenon can affect companies in a negative way and can affect the growth and profitability of a company. With the help of proper Accounting Services and Bookkeeping processes, it is possible for the management of a company to keep the finances of the business in check and take the correct decisions which are required for the future of the company.

Effects of Under Capitalization

There are various effects of undercapitalization on a business which are shown below:

1.The profitability of the company goes up.

As the rate of earnings of the business increases which has a direct correlation to the profitability of the company.

2.Equity share value goes Up

This can provide a good new to the shareholders of the company as the undercapitalization of a company can increase the value of shares of a company. a shareholder can even expect a raise in dividend prices to be received.

3.The financial reputation of the company increases

Because of higher profitability, the market value of the share will go up which in turn will increase the financial reputation of the company. this increase in reputation will help in the increase of goodwill of the company as well as assist in attracting more investors.

4.Increase in the Competition

Not everything is positive with the undercapitalization of a business. with an increase in profitability, the company will come in the eyes of the competing businesses. This will increase the competition which the business will have to face. 

5.The Government of May Increase Taxes

As the business will be performing well, the government will take note of this and may implement additional taxes or will remove subsidies. This will be done in light of an increase in the profitability of the company. with an increase in taxes, the government will be able to make more revenue from the company.

6.Effect on Society

The high profitability may lead to unhealthy speculation in the market relating to the shares of the company. The consumers may feel exploited at a point as the higher profits the company makes are associated with higher prices of the products.

7.Foul Play by the Management of the Business

Though there is no need for a business to pull any kind of shady act if the company is in profit but many managements may build secret cash reserves and show lower profitability. As the profits will be shown as a lesser amount then the companies will pay lesser taxes and will even take advantage of the subsidies provided by the government.

The capital structure of the business has huge importance in the planning and budgeting process. In case you are looking for assistance in planning and budgeting for your business in the UAE, then you must have a look at the services by JAXA Chartered Accountants.

They also provide many other financial services such as Auditing Services, Accounting Services, AT and Tax related services, and various other services that will help your company to flourish. For any more details on the services provided by JAXA, Contact Us. We will be happy to assist you.