Even without knowing its exact definition, you can just tell from the way the word sounds that undercapitalization is not good for your business. Undercapitalization occurs when a business holds insufficient funding — or capital — to support its operations. It is cause for serious concern about a potential major financial crisis for any business, but among contractors it is considered by many financial experts to be the leading cause of business failures.

Obviously, your company needs enough money to achieve your financial and business goals. More specifically, though, you should never underestimate how much capital is necessary to pursue the most profitable construction projects. Those contractors who aren’t fully aware or conscious of the money required to get a business up and running, and then sustain it as they work to establish a commercial foundation, may find themselves undercapitalized. The challenge is that, for any business, undercapitalization can quickly turn into a perpetual downward spiral from which it is difficult to recover.

Construction businesses need to keep their focus on attaining and maintaining the cash necessary to fund projects in terms of employee wages, equipment and supplier materials before the first installment of project payment.

The Impacts of Bad Cash Flow

Often, bad decisions are made when a company’s management is forced to wrestle with poor cash flow. Behind-schedule payments then have an increasingly detrimental effect on the company’s cash flow and start that downward slide into undercapitalization.

One cash flow issue you should try to avoid is mistaking cash receipt or positive cash flow with excess cash. Once money is spent, there’s no way to get it back, right? So one of the best tools you should employ to manage cash flow is your monthly budget and cash flow projections. Regular comparison of current and projected expenses, for example, will help keep you on track with spending.

While getting paid on time can be an ongoing struggle, there are steps you can take to address that issue as well. Understanding how each client handles accounts payable when you submit for draws will help you maintain a positive cash flow. Missing a draw or having poor-paying clients can lead to problems, so stay committed to your draw dates.

The Rewards of Planning

One of the most important skill sets to avoid undercapitalization is the ability to develop a comprehensive, accurate construction project plan. By determining your manpower, equipment and cash items up front, you will enhance the chances of success for a project. Basically, you never want to overestimate your team’s capabilities or underestimate your cash flow. If you have correctly accounted for what machinery, tools and skilled specialists will be needed and when they must be provided in the construction schedule, you can limit any periods of downtime or decreased productivity. Of course, you need to continually monitor and review a project plan to address any delays or other circumstances that may arise.

Always Strive for Sufficient Capitalization

In the end, undercapitalization can seriously restrict your business’s daily operations, growth and success. Sufficient capitalization, on the other hand, enables a business to handle slow periods in the business cycle or address other challenges that occasionally happen in the life of a company. More important, it can give you a competitive edge that positions you to grow and move ahead as a company.

In fact, according to the Small Business Administration publication Financing for the Small Business, one of the critical characteristics of successful entrepreneurship is having access to sufficient funds to run a business.