Cash flow is the essence of your small business, and managing your business well keeps it flowing. If your cash flow becomes a trickle, it may mean your enterprise is undercapitalized. While undercapitalization is not ideal, it doesn’t mean your business has to close its doors. You can learn how to prevent the situation and how to make the best of it, should it happen.
What is undercapitalization? It’s a small business term meaning a company or enterprise doesn’t have enough cash to maintain its business operations and pay its creditors. But this doesn’t necessarily mean the business isn’t making a profit. Reasons that businesses may become undercapitalized include failing to plan properly for customer demand, an unexpected increase in operating expenses, or making costly income tax mistakes. Investing in projects that don’t pan out or suffering a catastrophic accident without proper insurance can undercapitalize your business quickly. Your business can become undercapitalized if you haven’t set up a reserve fund and you’re not promptly collecting on invoices to maintain steady cash flow.
If you’re a boutique sunglasses maker in Ontario that begins receiving large orders from a multinational department store, you might realize you don’t have the capacity to fill the orders. When you don’t have the cash on hand to expand, your business is undercapitalized. To correct this, you could take out a loan or seek investors to increase your company’s financial capital. In this situation, you’re anticipating and planning on your future receipts being large enough to compensate those who provide the capital you need.
Effects of Undercapitalization
In small business terms, undercapitalization can be a big problem. Your business needs operating capital to pay staff, keep machines in working order, pay rent and creditors, service current customers, and market to new ones. When there isn’t enough liquidity, everything unravels. On the other hand, your business could be in a great spot even though it’s undercapitalized. Sometimes a lack of cash flow is a sign of high demand for products or services.
If your business is undercapitalized, it means you’re at a crossroads. Your options include renegotiating with lenders, acquiring new investors, taking out a business loan, or discovering ways to streamline your operations. If you pursue these activities successfully now or during a period of undercapitalization, you may end up better off than you were before.
How Can You Avoid Undercapitalization?
If you’re starting or thinking about starting a new business, consider these tips for avoiding undercapitalization at the beginning of your enterprise and down the road:
- Find a partner or mentor who can keep you accountable. Even CEOs of multinational corporations rely on boards of directors, so it’s a good idea to seek counsel from a knowledgeable advisor to help you avoid expensive mistakes.
- Start in a sector or industry you know. If you’re an expert in your chosen field, it’s likely you have a better idea about how much working capital your business needs for startup costs, cash flow, and future budgeting than if you’re starting in a field that’s new to you. Providing your expertise in an underserved niche helps instill investor confidence and lets you tap into a ready-made pool of consumers.
- Prepare a professional business plan. A great business plan can help you start on the right track and stay there. Your plan helps attract new investors or lenders whether you need extra capital now or later.
Giving your customers or clients the best service or product you can, and offering something they can’t find anywhere else encourages repeat business, and may generate new business referrals.
When your clients or customers receive top-quality products or services from you, you’re giving them more incentive to pay your invoices quickly, which helps you avoid undercapitalization. Improve your cash flow with invoices, payments, and expense tracking. See how much cash you have on hand with QuickBooks.