How Do We Identify Overtrading Companies or Undercapitalizated Companies?

WHEN DO YOU CONSIDER AN ENTITY BECOMES UNDERCAPITALIZE?

• Opposite of overcapitalization. 

• Undercapitalization would mean that the entity has not sufficient capital to provide for its own scale of operations.

• Evidenced by high borrowings from trade creditors or bank borrowings

• Undercapitalization can be a result of Overtrading:

      –can be due to over-ambitious expansion of business by increasing revenues but without  insufficient funding from the shareholders themselves. Substantial investments might be made on fixed assets like plant and machinery while the company does not have adequate shareholders’ equity ( capital, retained earnings, reserves) hence over-relying on liabilities as the funding source.

[ Refer to a more detailed article on OVERTRADING in my article in another accounting blog]

SOME OF THE TELL-TALES OR SYMPTOMS OF UNDERCAPITALIZATION

• Very low current ratio ( inability to pay current liabilities using its current assets)

• Very low proprietary ratio ( shareholders’ equity is very small compared to total assets)

• Too high an earnings per share ratio ( high net profits)